On July 1, Lighting Process, Inc. issues $10,000 ten‐year bonds, with a coupon rate of interest of 12% and semiannual interest payments payable on June 30 and December 31, when the market interest rate is 10%. Premium on bonds payable is a contra account to bonds payable that increases its value and is added to bonds payable in the long‐term liability section of the balance sheet. 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%. Discount on bonds payable is a contra account to bonds payable that decreases the value of the bonds and is subtracted from the bonds payable in the long‐term liability section of the balance sheet.
- The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued.
- Notice that under both methods of amortization, the book value at the time the bonds were issued ($104,100) moves toward the bond’s maturity value of $100,000.
- The issuer needs to recognize the financial liability when publishing bonds into the capital market and cash is received.
- Computing long-term bond prices involves finding present values using compound interest.
Likewise, the company needs to make the journal entry to account for the premium with the credit of the unamortized bond premium account. The amortization of the premium on bonds payable is the systematic movement of the amount of premium received when the corporation issued the bonds. The premium was received because the bonds’ stated interest rate was greater than the market interest rate. When a company issues bonds, investors may pay more than the face value of the bonds when the stated interest rate on the bonds exceeds the market interest rate.
Example of the Amortization of a Bond Premium
The FASB is currently reconsidering the reporting of these gains and losses as extraordinary items. For each month that the bond is outstanding, the “Interest Expense” is debited, and “Interest Payable” will be credited until the interest payment date comes around, e.g. every six months. Bonds payable represent a contractual obligation between a bond issuer and a bond purchaser. The relevant T accounts, along with a partial balance sheet as of 1 July 2020, are presented below. By the time the bonds reach maturity, their carrying value will have been reduced to their face value of $100,000.
This means that the corporation will be required to make semiannual interest payments of $4,500 ($100,000 x 9% x 6/12). The discounted price is the total present value of total cash flow discounted at the market rate. The difference between cash receive and par value is recorded as discounted on bonds payable. The unamortized amount will be net off with bonds payable to present in the balance sheet. The issuer needs to recognize the financial liability when publishing bonds into the capital market and cash is received.
It is also the same as the price of the bond, and the amount of cash that the issuer receives. On maturity, the book or carrying value will be equal to the face value of the bond. Both of these statements are true, regardless of whether issuance was at a premium, discount, or at par.
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In simple words, bonds are the contracts between lender and borrower, the amount of contract depends on the face value. However, the lender can receive the principal before the maturity date by selling contract to the capital market. The borrower will pay back the principal to whoever holds the contract on maturity date. The table below shows how to determine the price of Valenzuela Corporation’s 5-year, 12% bonds issued to yield.
Bonds Issued at a Premium Example: Carr
Over the life of the bond, this premium is amortized, and it reduces the amount of interest expense reported in the income statement. If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10%), Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). Spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20 (not to be confused with the periodic cash payment of $4,000).
The premium should be thought of as a reduction in interest expense that should be amortized over the life of the bond. The bonds were issued at a premium because the stated interest rate exceeded the prevailing market rate. This means the interest rates issued and printed on the bonds aren’t the same as the current market rates. 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.
This is due to the carrying value of bonds payable equal the balance of bonds payable plus the balance of unamortized bond premium that is recorded on the balance sheet at the time of issuing bonds. As mentioned, the unamortized bond premium that the company records when issuing the bond premium will need to be amortized over the life of the bond. This is done in order to have a carrying value of bonds payable on the balance sheet equal the face value of the bond at the end of the bond maturity.
The agreement containing the details of the bonds payable is known as the bond indenture. Assume that a corporation issues bonds payable having a maturity value of $1,000,000 and receives a premium of $60,000. The bonds mature in 20 years and there was no accrued interest at the time the bonds are issued. At the end of the third year, premium bonds payable will be zero and the carrying amount of bonds payable will be $ 100,000. 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.
Initially it is the difference between the cash received and the maturity value of the bond. The effective interest method of amortizing the discount to interest expense calculates the interest expense using the carrying value of the bonds and the market rate of interest at the time the bonds were issued. For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual https://accounting-services.net/ interest). 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). The $19 difference between the $469 interest expense and the $450 cash payment is the amount of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page.
The company issues the bond at a premium when the selling price of the bond is higher than its face value. It is not strange that the company can sell the bond at a premium if its bond gives a higher rate of return than the market rate of interest. For example, the contractual interest rate on the bonds is 10% but the market interest rate is only 8%. When the bonds issue at premium or discount, there will be a different balance between par value and cash received.
This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results. After the payment is recorded, the carrying value of the bonds payable on the balance sheet increases to $9,408 because the discount has decreased to $592 ($623–$31). 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. Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different.
Similarly, the journal entry on the date of maturity and principal repayment is essentially identical, since “Bonds Payable” is debited by $1 million while the “Cash” account is credited by $1 million. Company will pay a premium if they decide to buyback as the investor will lose some part of their interest income. It will happen when the market rate is declining, company can access the fund with a lower interest rate, so they can retire the bond early to save interest expense.
However, for financially sound companies, bond issuances represent a valuable method to raise capital while avoiding diluting equity interests as well as providing other benefits. The exact terms of bonds will differ from case to case and are clearly stated in the bond indenture agreement. Bond price is calculated by total the present value of interest and bond principal. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.