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Amortizing Bond Premium Using the Effective Interest Rate Method

To illustrate the premium on bonds payable, let’s assume that in early December 2022, a corporation has prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). The bond is dated as of January 1, 2023 and has a maturity date of December 31, 2027. The bond’s interest payment dates are June 30 and December 31 of each year.

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. As before, the final bond accounting journal would be to repay the face value of the bond with cash. 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. The straight line amortization method is one method of calculating how the premium or discount on bonds payable should be amortized to the interest expense account over the lifetime of the bond.

Amortizing Bond Premium with the Effective Interest Rate Method

Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.

• Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon interest rate of 9% and semiannual interest payments payable on June 30 and Dec. 31, issued on July 1 when the market interest rate is 10%.
• Study the following illustration, and observe that the Premium on Bonds Payable is established at $8,530, then reduced by $853 every interest date, bringing the final balance to zero at maturity.
• Notice that interest expense is the same each year, even though the net book value of the bond (bond plus remaining premium) is declining each year due to amortization.
• Don’t be put off by the work involved in the effective interest method.
• Usually, when the bond’s actual interest rates are higher than the market, it will become a premium bond.

An unamortized bond premium refers to the difference between a bond’s face value and its sale price. If a bond is sold at a discount, for instance, at 90 cents on the dollar, the issuer must still repay the full 100 cents of face value at par. Since this interest amount has not yet been paid to bondholders, it is a liability for the issuer. The premium account balance represents the difference (excess) between the cash received and the principal amount of the bonds. The premium account balance of $1,246 is amortized against interest expense over the twenty interest periods. Unlike the discount that results in additional interest expense when it is amortized, the amortization of premium decreases interest expense.

What is Premium on Bonds Payable?

As mentioned, the difference between the bond and market coupon rate can reveal that information. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2. The interest expense is amortized over the twenty periods during which interest is paid. Amortization of the discount may be done using the straight‐line or the effective interest method.

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. Thus, interest expense is recorded how to calculate premium on bonds payable as $4,324.44 for the first period, while $675.56 is recorded as premium amortization. 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.

What is premium on bonds payable?

The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond premium is not significant. Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life. By reducing the bond premium to $0, the bond’s book value will be decreasing from $104,100 on January 1, 2023 to $100,000 when the bonds mature on December 31, 2027.

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. Assume that a corporation prepares to issue bonds having a maturity value of $10,000,000 and a stated interest rate of 6%.

The total present value of the payments from the bond will be as follows. Bond investors need to know how to deal with bonds that cost more than their face value. Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes. Investing in stocks and bonds can help to build wealth for anyone with disposable income. The following T-account shows how the balance in Discount on Bonds Payable will be decreasing over the 5-year life of the bond. We’ll come back to these net interest expense figures once we have looked at the effective interest method – this will highlight the differences the two methods produce.