Premium on Bonds - Online Tutor, Practice Problems & Exam Prep

When bonds are issued at a premium, the stated interest rate exceeds the market rate, leading to a higher selling price than the face value. For example, if a company issues $50,000 in bonds at 9% interest while the market rate is 8%, the bonds may sell for $54,000. The premium is amortized over the bond's life, reducing interest expense. Each semiannual payment includes cash interest and premium amortization, affecting the balance sheet by decreasing liabilities and adjusting the carrying value of bonds payable accordingly.

Issuing Bonds at a Premium

Alright, so let's move on to the premium on bonds payable now. I want you guys to go ahead and after this lesson compare the discount and the premium. And see how much they have in common and are basically opposites of each other. So, what do you guys remember about the stated rate and the market rate when we're talking about premiums? When the stated rate, let's say is 12%, now we're saying with our bonds, "Hey, our bonds are offering 12% and the market, all similar bonds to ours, are only offering 10%." People are going to prefer ours, right? Ours are more enticing because we're paying a higher interest rate. So, this is when a premium exists when the stated rate is greater than the market rate.

Let's go ahead and do our summary table right quick, and remember, we've dealt with these other ones already. We dealt with the situation where the stated rate and the market rate are equal, and this was a face-value bond, sometimes called a par value bond, and the price of the bond will be equal to the face value in that case. Now, what about the situation we just discussed where the stated rate was less than the market rate? The stated rate is 8%, while the market rate is 10%. Well, the price of the bond is going to be less, right? Our bond in that case is less enticing than the market, because we're offering less interest. So investors will pay less for it, and they will pay at a discount. Now, in this video, we're going to be focused on the premium. That's a situation where we're offering more, just like we said. We're offering 12% when the market offers 10%. Well, the price of the bond is going to be greater than the par value. Right? And that's because our interest rate is higher; they're going to be sold at a premium.

Let's go ahead and see how the issuance entry, when we first issue the bonds, what that's going to look like when we are dealing with a premium situation. On January 1, 2018, ABC Company issues \\( \$50,000 \\) of \\( 9\% \\) bonds payable, maturing in 5 years. Remember, this \\( \$50,000 \\) is the principal amount. The face value of the bonds. And that's the amount that will calculate our cash interest. The bond says they're going to pay \\( 9\% \\) interest, and they mature in 5 years. Right? It's 5 years, 5-year bonds and interest is payable semi-annually, which means 2 payments per year, right? Every 6 months, we are going to make interest payments. Semiannual bonds tend to be more common because it's a little more complicated; we've got to make 2 payments per year. January 1st and July 1st are those interest payment dates.

Now notice, the market interest rate in this case is \\( 8\% \\), right? We're offering \\( 9\% \\). The market is only offering \\( 8\% \\). Well, our bonds are more enticing. They're going to be sold at a premium, and that's exactly what we see right here. The bonds were issued at \\( 108\% \\) of their face value. So the \\( 108\% \\) means \\( 108\% \\) of the face value. Now that could have been any number, but they have to give it to you, right? In this case, they sold for \\( 108\% \\) of the face value. Let's go ahead and see how much cash we received. That's what it tells us. The \\( 108\% \\) tells us how much cash we received, and that's going to be the \\( \$50,000 \times 1.08 \\), because it's \\( 108\% \\), which is \\( 1.08 \\). So let's go ahead and see what that comes out to. \\( \$50,000 \times 1.08 \\), well, that comes out to \\( \$54,000 \\) and that's the amount of cash we're going to receive, from selling these bonds. So that's going to be our debit to cash. We are going to receive \\( \$54,000 \\) in cash. Okay? So that is our debit, in this entry. And we're going to have a credit. We owe money now, right? We took on this liability for bonds payable.

Well, what is going to be our credit to bonds payable in this case? Is it going to be \\( \$54,000 \\)? No, just like we said, right? The bonds payable is always going to be in the amount of the face value. The face value of these bonds are \\( \$50,000 \\) and this always has to be always face value going into the bonds payable account, \\( \$50,000 \\) is the bonds payable, but this doesn't balance, right? We've got debits of \\( \$54,000 \\) and credits of \\( \$50,000 \\) in this case. So we need \\( \$4,000 \\) more credits. So we're going to need \\( \$4,000 \\) more in credits over here and guess what that's going to be? That's going to be our premium on bonds payable. Premium on bonds payable. I'm going to put premiums on VP. That's usually how we abbreviate this, premiums on bond payable. Okay? So that \\( \$4,000 \\) extra is going to be sitting in another account. We keep the principal account in the bonds payable account, and then we have this related account. Not necessarily a contra account because it's increasing the value, right? It has a credit balance. We have the credit balance of \\( \$50,000 \\) plus another credit balance of \\( \$4,000 \\). So it's increasing the value of bonds payable based on this extra cash we received. Okay? So when we see our balance sheet, our balance sheet is going to show this cash we received the \\( \$54,000 \\). It's going to be increasing our cash balance. But on our liabilities, now we're going to be showing our bonds payable account. So, when we show our balance sheet, we're going to have our bonds payable account sitting on \\( \$50,000 \\) as a credit, right? It's going to show a liability of \\( \$50,000 \\), but it's also going to say plus premium, right? Because the carrying value of the bond is not just the \\( \$50,000 \\). It also has this premium associated with it of \\( \$4,000 \\). So when we show our balance sheet, it's going to show a bonds payable of \\( \$54,000 \\). Or excuse me, not just the bonds payable The bonds payable plus the premium is going to show a balance of \\( \$54,000 \\), okay? And that's equal to the cash we received, so our equation stays balanced here. Okay? So it's a big note when we make our journal entry, that the bonds payable account always just has the face value of the bonds and then we store the difference from the cash we received and the bonds payable in either the discount or the premium. Okay? So let's go ahead and move on to our interest expense journal entry.

Premium Bonds:Interest Expense, Amortization, and Cash

Alright. Let's continue here with our interest expense journal entries, starting with the one on July 1, 2018. Okay? So remember, this bond pays interest semiannually, right? That means we're paying interest twice per year, basically every 6 months, right? So our first interest payment is going to happen on July 1st. We issued them on January 1st, but since we're not going to pay any interest on the day we issued them, as no time has passed, the first interest payment occurs on July 1st. And remember, up above, we discussed the premium that was $4,000, right? We had a $4,000 premium that was increasing the value of the bonds. Well, we're going to use the straight line method of amortization. There's another method that's more complicated called the effective interest method. The effective interest method is GAAP, but we're using the straight line method here because it's easier and is generally used in your class. If your teacher wants to be a little more complicated or your textbook goes into more details, we'll go into the details of the effective interest method later.

So, when we use the straight line method, what we do is take the total premium or total discount amount, which in this case was a $4,000 premium, right? Our premium was $4,000 and we divide it by the total number of interest payments. Just like we did with the straight line method for depreciation, we had the number of years that we are depreciating over. Here, it's the same; we're amortizing over 10 periods. We have a 5 year bond and we're paying interest twice per year, so 5 years times 2 times per year gives us 10 total interest payments. So each time, we're going to amortize some of this premium. $4,000 divided by 10 gives us $400 per interest payment that we are going to amortize. So we're going to have our $400 amortization of our premium, but what about the cash interest, right? We are going to pay some interest in cash that we owe to the investors. The cash interest will be calculated as $50,000 in principal times the 9% annual interest rate, but that's an annual rate, and since it's been only 6 months, we divide by 2. $50,000 times 0.09 divided by 2 results in $2,250, which is the amount of cash interest we're going to pay, but then we're also going to amortize this premium.

So we're going to have a credit to cash here in the amount of $2,250 because that's the amount of cash that's actually coming out of our pocket. This premium, we're going to start getting rid of it over the life of the bonds payable. As calculated, it's going to be $400 per interest payment. To eliminate the premium, because it has a credit balance, we're going to use debits. So we're going to have a debit here to premium on bonds payable, and that's going to be in the amount of $400. Over the 10 payment periods, we're going to eliminate $400 each time, and after the 10 payment periods are over, it's going to be completely gone. Let's look at that in a T-account quickly. We had the premium on bonds payable, and it had a $4,000 credit balance to start with. In this journal entry, we just debited $400, leaving it with a $3,600 credit balance.

What does this do to our balance sheet? Well, when we show our balance sheet, we're going to show our bonds payable, and the bonds payable account will list the principal amount, the face value of the bonds, at $50,000. Then we add the premium, which is now $3,600, showing a carrying value of the bonds at $53,600. Originally, in our first entry, they had a carrying value of $54,000, with the $50,000 plus the $4,000 premium. However, since we're amortizing some of it into the interest expense, the premium has decreased. Now, our journal entry isn't complete yet. We've got a credit for $2,250, a debit for $400, and we need one more debit to balance this out, which is the $1,850 necessary to make the entries balance. This journal entry reflects our interest expense and the movement in the bond's premium. Ultimately, our liabilities decrease, matching the reality that we're moving toward paying off the actual $50,000 that we're eventually going to repay.

And there we go. We're balanced here. We've seen our cash decrease by $2,250, and we saw our liabilities decrease as well due to this amortization. This decreases equity by $1,850 due to the interest expense, reflecting the true costs on our income statement. Cool. Alright. Let's go ahead and move on to the next journal entry.

Premium Bonds:Interest Expense, Amortization, and Interest Payable

Alright, so as time keeps passing we're going to be making more entries for interest expense every 6 months. So now we reach the end of the year and we're going to have to accrue for those 6 months that have passed. Notice that we don't pay interest until January 1st, but it's December 31st, right? This is December 31st when we're going to say, hey, check out our financial statements on December 31st. Well, we haven't paid this interest yet, so we're not going to decrease our cash, we're going to have interest payable like we saw in our previous entries. But all of our numbers are going to stay the same. Our premium amortization just like we calculated before, I'm going to put amortization. That's going to be the 4,000 that was in the premium divided by the 10 periods, right? It came out to 400 per period. And then we also had our cash interest which in this case, it's not cash, right? Because we're not paying it until January 1st, the next day. This is going to be our interest payable because we haven't paid it yet, so we have this liability. That's going to be 50,000 * 0.09 / 2 , just like we did before. And that comes out to 2250. And notice how similar this journal entry is going to be to the one we just made. So we're going to have interest payable as a credit, right? This is a liability until we pay it off tomorrow for 2250.

We're going to have to credit our, excuse me. That's our only credit in this case. We're going to debit our premium just like we did in the previous entry to lower the value of the premium over the life of the bond by the 400 per period. And we're going to have interest expense as the difference between the 2. And that's going to be 1850. Notice all the numbers are the same. The only difference is the interest payable because we're not paying it until next period, right? So you can imagine on the first of 2019, the very next day, we would debit our interest payable to get rid of it and that would be in 2250 and we would pay it in cash 2250. Now, I want to show you real quick. I want to make a note that our premium on bonds payable is going to keep decreasing. Right?

It started let me do it in a different color so it stands out. It started with a $4,000 credit balance when we first issue the bonds, and then each time that we pay interest, we're lowering it by 400. Now we've paid interest twice, well we've lowered it by 400 twice, so the premium is sitting at a $3,200 balance. That's going to keep lowering the balance of our liability that started at 54,000 and we're going to keep lowering it over the life of the bond until only the principal value is left. Okay? So let's go ahead and see what happened here. First, we have our interest expense, right? Our interest expense is part of equity. And that's going to lower our equity because it's an expense, 1850. And what about the premium on bonds payable? The premium on bonds payable, well, this is lowering our liabilities, just like we saw in the previous entry, right? $400 less of liabilities, just like we saw. Our premium had this credit balance of 4,000, then we lowered it by 400 in the previous entry, now another 400 in this entry. So it keeps bringing down the value of our liabilities. Finally, we have the interest payable which is also a liability and that increases our liabilities by 2,250 until we pay it off the next day. Right? When we pay it off the next day, well, that would have increased our liabilities by 2,250 because we owe 2,250 in the future now. Well, the very next day when we pay it off, we get rid of that and we would pay it off in cash, and that would get rid of that. Right? So that evens out and you'll notice that, our equation stays balanced here, right? So let's go ahead and move on to our final journal entry on the principal repayment date.

Premium Bonds:Repaying Principal at Maturity

All right, so let's finish up here with the repayment of principal on the maturity date. Time has passed, we've made interest payments over the 5 years and we've been making interest expense journal entries like we saw in the previous two journal entries. Okay? So if we look at our premium account, it started with a balance of 4,000, as a credit balance. In each of our interest expense journal entries, we were taking away 400 each time. We've done this 10 times now, so that gets rid of the entire balance and there's no premium left. What's left in the liability? It's the bonds payable account. The bonds payable that had 50,000 in the principal amount. Well, it's finally time to pay off that principal and we're going to make a journal entry to pay off that principal.

Now, if we were to look on our balance sheet at our liabilities, we would see bonds payable of 50,000 plus a premium of 0. At this point, we've made all of our journal entries for interest expense, we've paid all our interest expense and there's no premium left. We've amortized the entire amount into interest expense. So all that's left is the 50,000 in the bonds payable account. We're going to finally pay that off. We're going to debit bonds payable for 50,000 and we're going to credit cash for 50,000 because we're paying them in cash. So we credit the cash to get rid of it, and that's it. The final entry is usually very simple. All we got to do is get rid of the bonds payable and credit the cash. Cool?

All right. So that's all that happened here. The cash is going down by 50,000 because we paid out 50,000 in cash and our bonds payable. We no longer owe this liability. We've paid it off. So we get rid of the liability, it also decreases by 50,000. Very simple. The toughest thing about this is amortizing the premium and amortizing the discount. Especially where I see students struggle is whether we're going to credit the premium when we're discounting it or debit the premium when we're amortizing it. Right? All you got to think about is that original balance. When you think about a premium, it's increasing the balance of our liability. So it's going to have a credit balance because it increases a liability with a credit. So how do we get rid of it? With debits. So, it's going to be debits to the premium to get rid of it over the course of the interest expense, and the opposite happens with the discount.

Before you finish this lesson, I want you to compare what you did in the previous few pages with the discount on bonds payable and compare it to what we just did with the premium on bonds payable, and you'll see that it's very similar. Right? All right. Let's go ahead and wrap up with a practice problem and then move on to the next topic.

The carrying value (i.e. book value) of Bonds Payable is equal to:

• A. Bonds Payable + Accrued Interest
• B. Bonds Payable – Premium on Bonds Payable
• C. Bonds Payable – Amortization of Premium on Bonds Payable
• D. Bonds Payable – Discount on Bonds Payable

Here’s what students ask on this topic:

What is a premium on bonds payable?

A premium on bonds payable occurs when bonds are issued at a price higher than their face value. This happens when the stated interest rate on the bonds is higher than the prevailing market interest rate. For example, if a company issues $50,000 in bonds with a 9% interest rate while the market rate is 8%, the bonds might sell for $54,000. The $4,000 difference is the premium, which is amortized over the life of the bond, reducing the interest expense reported on the income statement.

How do you calculate the premium on bonds payable?

The premium on bonds payable is calculated by multiplying the face value of the bonds by the percentage above par at which they are sold. For instance, if $50,000 in bonds are issued at 108% of their face value, the calculation is:

$\mathrm{50,000}\times 1.08=\mathrm{54,000}$

The premium is the difference between the selling price and the face value, which in this case is $4,000.

How is the premium on bonds payable amortized?

The premium on bonds payable is amortized over the life of the bond using either the straight-line method or the effective interest method. In the straight-line method, the total premium is divided by the number of interest payment periods. For example, if the premium is $4,000 and the bond pays interest semiannually over 5 years (10 periods), the amortization per period is:

$\mathrm{4,000}÷10=400$

This amount is then used to reduce the premium and interest expense in each period.

What is the journal entry for issuing bonds at a premium?

When bonds are issued at a premium, the journal entry includes debiting cash for the amount received, crediting bonds payable for the face value, and crediting premium on bonds payable for the difference. For example, if $50,000 in bonds are issued at 108% (selling for $54,000), the entry is:

Debit Cash $54,000

Credit Bonds Payable $50,000

Credit Premium on Bonds Payable $4,000

How does the premium on bonds payable affect the balance sheet?

The premium on bonds payable affects the balance sheet by increasing the carrying value of the bonds payable. For instance, if the face value of the bonds is $50,000 and the premium is $4,000, the carrying value shown on the balance sheet will be $54,000. Over time, as the premium is amortized, the carrying value will decrease, eventually equaling the face value of the bonds at maturity.