When a company prepares to issue or sell a bond to investors, it may assume that the proper interest rate will be 9%. The bond will sell for its face value if investors are ready to accept the 9% interest rate. If the market interest rate at the time the bond is issued is less than 9%, the corporation will receive more than the bond’s face value. The premium on bonds due, bond premium, or premium is the amount received for the bond that is in excess of the bond’s face amount (excluding accumulated interest).
Let’s pretend that a firm issued a $100,000 bond in early December 2019 with a stated interest rate of 9%. (9 percent per year). The bond was issued on January 1, 2020, and it will mature on December 31, 2024. The bond’s interest is paid twice a year, on June 30 and December 31. This means the corporation will be compelled to pay $4,500 in interest every six months ($100,000 x 9% x 6/12).
Let’s pretend that the market interest rate for this bond decreases to 8% right before it is sold on January 1st. Instead of altering the bond’s stated interest rate to 8%, the firm decides to issue a 9% bond on January 1, 2020. The corporation will receive more than the bond’s face value because this 9% bond will be sold when the market interest rate is 8%.
Assume that this 9% bond, issued in an 8% market, will sell for $104,100 + $0 in interest. On January 1, 2020, the corporation’s journal entry to reflect the bond’s issuance will be:
Premium on Bonds Payable is a liability account that will always appear alongside Bonds Payable on the balance sheet. To put it another way, if the bonds are a long-term obligation, both Bonds Payable and Premium on Bonds Payable will be long-term liabilities on the balance sheet. The book value, also known as the carrying value of the bonds, is the sum of these two accounts. This bond’s book value is $104,100 as of January 1, 2020 ($100,000 credit balance in Bonds Payable + $4,100 credit balance in Premium on Bonds Payable).
Premium on Bonds Payable with Straight-Line Amortization
The balance in the account Premium on Bonds Payable must be lowered to zero over the life of the bond. The bond premium of $4,100 in our case must be decreased to $0 over the bond’s 5-year term. The bond’s book value will drop from $104,100 on January 1, 2020 to $100,000 when the bonds mature on December 31, 2024 if the bond premium is reduced to zero. Amortization is the process of reducing the bond premium in a rational and systematic manner.
The corporation got a bond premium of $4,100 since its interest payments to bondholders will be higher than the amount demanded by market interest rates. As a result, the account Interest Expense will be used to amortize the bond premium. During the life of the bond, there must be a credit to Interest Expense and a debit to Premium on Bonds Payable at each accounting period. The straight-line method of amortization will be demonstrated in this section. (We’ll show you how to use the effective interest rate method in Part 10.)
Straight-Line Amortization of Bond Premium on Annual Financial Statements
The amortization of the bond premium can be recorded once a year if a firm only produces yearly financial statements and its accounting year ends on December 31. The annual straight-line amortization of the bond premium for a 9% $100,000 bond issued for $104,100 and due in 5 years will be $820 ($4,100 divided by 5 years).
When a company only publishes annual financial statements, however, the amortization of the bond premium is frequently recognized when the company makes semiannual interest payments. On June 30 and December 31, the journal entries will be as follows:
The net sum of $8,180 comes from the interest payments and bond amortization ($4,500 of interest paid on June 30 + $4,500 of interest paid on December 31 minus $410 of amortization on June 30 and minus $410 of amortization on December 31). This $8,180 will be reported in the Interest Expense account for the year 2020, as shown in the T-account below:
Under the straight-line technique of amortization, the balance in the account Premium on Bonds Payable will decline over the 5-year life of the bonds as shown in the T-account below.
The following table illustrates how the bond’s book value will decline from $104,100 to $100,000 at maturity:
Straight-Line Amortization of Bond Premium on Monthly Financial Statements
If monthly financial statements are published, the bond premium will be amortized at a rate of $68.33 per month ($4,100 of bond premium divided by 60 months of bond life). The 12 monthly amortization entries, as well as the semiannual interest payments of June 30 and December 31, are listed below for the year 2020:
If all of the bonds remain outstanding, the journal entries for the years 2021 through 2024 will be comparable.
How do you record a premium bond?
If the bonds were issued with a discount or premium, the amount must be amortized over the life of the bonds. If the quantity is little, a straight-line calculation can be used. Calculate the periodic amortization using the effective interest method if the amount is significant or if a higher level of accuracy is desired.
If the issuer received a discount on bonds payable, the periodic entry is a debit to interest expense and a credit to discount on bonds payable, which increases the issuer’s overall interest expense. The entry is a debit to premium on bonds payable and a credit to interest expenditure if there was a premium on bonds payable; this reduces the issuer’s overall interest expense.
The amortization of bond issuance costs is recorded as a credit to financing expenditures and a negative to other assets on a quarterly basis.
Key Points
- When a bond is issued, the corporation must debit cash for the amount received, credit a bond payable liability account for the face value of the bonds, and credit a bond premium account for the difference between the sale price and the face value of the bonds.
- To determine the bond premium amortization rate, a corporation divides the bond premium amount by the number of interest payments that will be paid over the bond’s period.
- When the corporation records interest payments, it credits cash with the amount paid to the bond holder, debits the bond premium account with the amortization rate, and credits interest expense with the difference between the amount paid in interest and the premium’s amortization for the period.
- The corporation must pay the bondholder the face amount of the bond, finish amortizing the premium, and pay any remaining interest obligations when the bond reaches maturity. The bond premium and bond payable account must equal zero once all final journal entries have been made.
On the balance sheet, where does the premium on bonds payable go?
Premium on bonds payable is a counter account that enhances the value of bonds payable and is added to bonds payable in the long-term liabilities area of the balance sheet.
What is a bond payable account premium?
The excess amount by which bonds are issued over their face value is known as premium on bonds payable. This is recorded as a liability on the issuer’s books and is amortized to interest expense throughout the bonds’ remaining life. This amortization has the net effect of lowering the amount of interest expenditure associated with the bonds.
When the market interest rate is lower than the bond’s stated interest rate, a premium is paid. Investors are willing to pay more for the bond in this situation, resulting in a premium. They will pay a higher interest rate in order to achieve an effective interest rate that is comparable to the market rate.
On a balance sheet, how do you record bonds?
Bonds payable are so recorded on the liabilities side of the balance sheet. Both financial modeling and accounting rely heavily on financial statements. Bonds payable are typically classified as non-current liabilities. Bonds can be sold at a discount, at a premium, or at par.
Is the bond premium accounted for on the income statement?
The systematic movement of the amount of premium received when the corporation issued the bonds is known as amortization of the premium on bonds payable. The premium was paid because the advertised interest rate on the bonds was higher than the market rate.
The premium is accounted for separately in a bond-related liability account. The premium amount will be gradually shifted to the income statement as a reduction of Bond Interest Expense over the life of the bonds.
When you issue a bond, you’re basically borrowing money. What exactly is a journal entry?
Keep in mind that when a firm issues bonds at a premium or discount, the amount of bond interest expenditure recorded each month is different from the amount of bond interest paid. The amount of interest expenditure we record semi-annually is reduced by a premium. The bond pays interest every six months on June 30 and December 31 in our case. The premium will be amortized using the straight-line technique, which means dividing the whole amount of the premium by the total number of interest payments. The premium amortization in this case will be $5,250 discount amount / 6 interest payments (3 years x 2 interest payments each year). To record the semi-annual interest payment and discount amortization, make the following entry:
We would have totally amortized or erased the premium, just as we would with a discount, resulting in a zero balance in the premium account.
At maturity, our entry would be:
Between interest dates, bonds are issued at face value. Companies don’t usually issue bonds on the same day as they begin to pay interest. Interest begins to accumulate from the most recent interest date, regardless of when the bonds are formally issued. Bonds are selling at a stated price “plus accumulated interest,” according to firms. At each interest date, the issuer must pay all six months’ interest to bondholders. As a result, investors who buy bonds after they start earning interest must pay the seller for the unearned interest that has accrued since the previous interest date. When bondholders receive their first six months’ interest check, they are compensated for the interest that has accrued.
Assume Valley issued its bonds on May 31, rather than December 31, based on the facts for the 2010 December 31 Valley bonds. The following information is required:
This entry debits Cash and credits Bond Interest Payable with the $5,000 received for accumulated interest.
This entry records a $1,000 interest expense on $100,000 in outstanding bonds for one month. Valley got $5,000 in interest from bondholders on May 31 and is now returning it to them.
When bonds are issued at a premium, is the face amount credited to the bonds payable account?
When bonds are sold at a discount, the face amount is applied to the bonds payable account. A debenture bond is a type of mortgage bond. The process of approximating interest rates is known as imputation, and the resultant interest rate is known as an imputed interest rate.
On a balance sheet, how do you record discounts on bonds payable?
When a company prepares a bond to be issued/sold to investors, it may need to factor in the interest rate that will appear on the bond’s face and in its legal contract. Assume that the company issues a $100,000 bond with a 9% interest rate. A financial crisis happens just before the bond is issued, and the market interest rate for this sort of bond rises to 10%. If the company proceeds with the sale of its 9% bond in the 10% market, it will receive less than $100,000. A bond is considered to have been sold at a discount when it is sold for less than its face value. The difference between the amount received (excluding accrued interest) and the bond’s face amount is known as the discount. The terms “discount on bonds payable,” “bond discount,” and “discount” are used to describe the difference.
Assume a corporation prepares a 9% $100,000 bond dated January 1, 2020 in early December 2019 to demonstrate the discount on bonds payable. Until the bond matures on December 31, 2024, interest payments of $4,500 ($100,000 x 9% x 6/12) will be due on June 30 and December 31 each year.
Let’s now say that the market interest rate on this bond rises to 10% immediately before it is offered to investors on January 1st. Rather of revising the bond paperwork to reflect the market interest rate, the firm decides to sell the 9% bond. Because the corporation is selling its 9% bond in a market that is wanting 10%, the corporation will receive less than the bond’s face value.
Assume that on January 1, 2020, the 9 percent bond is sold in the 10% market for $96,149 plus $0 accrued interest to demonstrate the accounting for bonds payable issued at a discount. The following is the journal entry that the corporation will make to document the bond sale:
Because it will have a debit balance, the account Discount on Bonds Payable (or Bond Discount or Unamortized Bond Discount) is a contra liability account. The account Bonds Payable will always show a discount on Bonds Payable on the balance sheet. In other words, if the bond is a long-term liability, the balance sheet will show both Bonds Payable and Discount on Bonds Payable as long-term liabilities. The book value or carrying value of the bonds is the sum of these two accounts, or the net of these two accounts. The book value of this bond on January 1, 2020 is $96,149 (the $100,000 credit balance in Bonds Payable minus the $3,851 debit amount in Discount on Bonds Payable).
Discount on Bonds Payable with Straight-Line Amortization
The sum in the account Discount on Bonds Payable must be lowered to zero over the life of the bond. Amortizing or amortization is the process of reducing the account amount in a rational manner. Because the difference between a bond’s stated and market interest rates causes the discount, the journal entry for amortizing the discount will use the account Interest Expense.
The bond discount of $3,851 in our example arises from the firm getting only $96,149 from investors but needing to pay them $100,000 when the bond matures. Over the life of the bonds, the $3,851 discount is recognized as an additional interest charge. Straight-line amortization occurs when the same amount of bond discount is recorded each year. The straight-line amortization in this case would be $770.20 ($3,851 divided by the bond’s 5-year duration).
Straight-Line Amortization of Bond Discount on Annual Financial Statements
If a company only publishes yearly financial statements on December 31, bond discount amortization is frequently reflected when the company makes semiannual interest payments. In our case, the straight-line technique will result in the following journal entries for 2020:
The total interest expense for 2020 will be $9,770 (two semiannual interest payments of $4,500 each + two semiannual bond discount amortizations of $385 each). The entries for the year 2020 are shown in the T-account for Interest Expense:
The T-account below shows how the balance in Discount on Bonds Payable will decrease over the bond’s 5-year tenure.
The bond’s book value will increase from $96,149 on the date the bond was issued to $100,000 at maturity as the bond discount is amortized:
Straight-Line Amortization of Bond Discount on Monthly Financial Statements
The monthly amount of bond discount amortization under the straight-line technique will be $64.18 ($3,851 of bond discount divided by the bond’s life of 60 months) if the corporation releases monthly financial statements. During the year 2020, the 12 monthly journal entries for bond interest and bond discount amortization, as well as the entries for the June 30 and December 31 semiannual interest payments, will result in the following 14 entries:
If all of the bonds remain outstanding, the journal entries for the future years will be similar.