Amortizing Premiums and Discounts Financial Accounting

Each period the interest expense (4,249) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) less the premium amortized (551). When a bond is sold at a discount, the amount of the bond discount must be amortized to interest expense over the life of the bond. Thus, interest expense is recorded 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.

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Recordkeeping for Discount Amortizations

You can also think of this as the difference between the amount of money that investors pay for the bond and the actual price printed on the bond. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. To create an inventory, enter information about your paper bonds, one bond at a time, into the Calculator. Thus, the bonds are sold at a discount of $7,360.09 ($100,000 in face value minus proceeds of $92,639.91).

The effective interest method is a more accurate method of amortization, but also calls for a more complicated calculation, since it changes in each accounting period. This method is required for the amortization of larger premiums, since using the straight-line method would materially skew the company’s results. 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 reason is that the bond premium of $4,100 is being amortized to interest expense over the life of the bond.

Premium on Bonds Payable with Straight-Line Amortization

The journal entries for the years 2023 through 2026 will be similar if all of the bonds remain outstanding. Beware of internet scams with a picture of this page claiming you can enter your birth certificate number to access bonds owed to you. Repeat this process for each year, using the updated carrying value to calculate the interest expense, until the bond’s carrying value equals its face value at maturity.

Suppose XYZ Corp. issues $100,000 of bonds that pay a semiannual coupon of 5%, or 10% per year. These bonds are seen to be very attractive, and investors think the borrower is too good of a risk to pay 10% per year. ABC must then reduce the $100,000 premium on its bonds payable during each accounting period that the bonds are outstanding, until the balance in the Premium on Bonds Payable account is zero when the company has to pay back the investors.

Definition of Amortization of Premium on Bonds Payable

By the end of the 5-year period, the carrying value of the bond will equal its face value of $100,000. The total bond premium is equal to the market value of the bond less the face value. For instance, with a 10-year bond paying 6% interest that has a $1,000 face value and currently costs $1,080 in the market, the bond premium is the $80 difference between the two figures. An identical process is followed if the bonds are issued at a discount as the following example shows. In other words, a premium is the difference between the par value and the market price when the par value is less than the par value.

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Let’s assume that just prior to selling the bond on January 1, the market interest rate for this bond drops to 8%. Rather than changing the bond’s stated interest rate to 8%, the corporation proceeds to issue the 9% bond on January 1, 2022. Since this 9% bond will be sold when the market interest rate is 8%, the corporation will receive more than the bond’s face value. Reducing the balance in the account Premium on Bonds Payable by the same how to calculate premium on bonds payable amount each period is known as the straight-line method of amortization. A more precise method, the effective interest rate method of amortization, is preferred when the amount of the premium is a large amount. Since it usually takes companies months to finalize bond proposals, develop the legal agreements, and place the bonds on the market for the public to purchase, the original bond terms rarely match the current market interest rates.

• Below is a comparison of the amount of interest expense reported under the effective interest rate method and the straight-line method.
• At that time, the recorded amount of the bond has declined to its $1,000 face value, which is the amount the issuer will pay back to investors.
• Premium on bonds payable (or bond premium) occurs when bonds payable are issued for an amount greater than their face or maturity amount.
• 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.
• This means that when a bond’s book value decreases, the amount of interest expense will decrease.
• The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant.

Assume XYZ Corp. sells $100,000 of five-year bonds with a semiannual coupon of 5%, or 10% per year. Investors think the company is risky, so they demand a 12% yield to maturity for buying these bonds. Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis.