Schultz will have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000 at maturity). Note that Valley does not need any interest adjusting entries because the interest payment date falls on the last day of the accounting period. At the end of ninth year, Valley would reclassify premium on bonds payable the bonds as a current liability because they will be paid within the next year. If a bond is issued at a premium or at a discount, the amount will be amortized over the years through to its maturity. The actual interest paid out (also known as the coupon) will be higher than the expense.
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.
Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. If the market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. Another way to illustrate this problem is to note that total borrowing cost is reduced by the $8,530 premium, since less is to be repaid at maturity than was borrowed up front. If a company is performing well, its bonds will usually attract buying interest from investors. In the process, the bond’s price rises as investors are willing to pay more for the creditworthy bond from the financially viable issuer.
- 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.
- See Table 4 for interest expense and carrying value calculations over the life of the bonds using the effective interest method of amortizing the premium.
- This typically happens when the coupon rate (the interest rate stated on the bond) is higher than the prevailing market interest rates at the time of issue.
- 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.
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.
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).
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.
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.
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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.
Premium on Bonds Payable with Straight-Line Amortization
If interest dates fall on other than balance sheet dates, the company must accrue interest in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest date and issued at face value between interest dates. 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). The bond is dated as of January 1, 2022 and has a maturity date of December 31, 2026.
The format of the journal entry for amortization of the bond premium is the same under either method of amortization – only the amounts change. The difference is the amortization that reduces the premium on the bonds payable account. It is also true for a discounted bond, however, in that instance, the effects are reversed. Over the life of the bonds, the $150,000 premium is to be accounted for as a reduction of the corporation’s interest expense.
Watch It: Bonds issued at a premium
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 https://accounting-services.net/ 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.
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.
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 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.