Premium Bonds: Keeping the Books
Bonds issued at a premium are reflected here to illustrate the process.
Supposing Valenzuela Corporation issued $100,000 in 5-year 12% term bonds on January 2, 2020. Interest is due every 6 months, on the 2nd of January and 1st of July.
However, in this example, the bonds are issued at a time when the going interest rate for bonds of this type is 10%.
This entry is similar to the one made when recording bonds given at a discount, with the exception that a premium account is used here instead.
The full sum of the sale is taken out of cash, and the face value of the bonds is credited to the bonds payable account. A premium bonds account credit of $7,722 results from this discrepancy.
An adjunct account is the premium on bonds payable account because its balance must be added to the bonds payable balance when calculating the bonds’ carrying value.
The following Valenzuela Corporation balance sheet was generated on January 2, 2020, right after the bonds were issued as an example.
Bond prices can be calculated using present value.
The value of premium-issued bonds can be calculated using the methods described below.
You can skip this section if you haven’t yet discussed the idea of current value.
Yield bonds issued by Valenzuela Corporation have a maturity of 5 years and a coupon rate of 12%.
Accounting for Bonds Issued at a Discount uses discount computations that are analogous to what we see here.
The main distinction is a 5% semiannual yield discount applied to the cash flows.
The Premium Account and What It Is
The premium can be viewed as a deferral of interest payments spread out across the bond’s term.
Since the advertised interest rate was higher than the going market rate, the bonds were issued at a premium.
Bondholders receive $6,000 ($100,000 x.06) every six months, whereas 10% yielding investments would only pay $5,000 ($100,000 x.05) in semiannual interest.
The bondholders’ premium of $7,722 is the present value of a $1,000 difference that will be paid out over the next 10 interest payments.
Bonds are popular investments, therefore the price was bid up to $107,722; the premium of $7,722 will be applied to lower interest costs.
The matching convention mandates recognition of the matching over the life of the bond, even though the borrower receives all of the cash at the moment of issue.
The $7,722 premium can be amortized using the simple interest or the straight line methods. Below, we provide a summary of different approaches using premium and discount examples.
The Direct Approach
The premium of $7,722 is amortized using the straight-line approach at a rate of $772 ($7,722 / 10) per interest period, with a total amortization of $7,722.
With $6,000 in cash interest and $772 in premium amortization, the total interest expenditure each period comes to $5,228.
The $5,228 can also be computed by dividing the total interest expense of $52,278 over the bond’s life, which is divided into 10 interest periods.
Below is a table displaying the straight-line technique of amortization applied to this bond issue.
This entry, along with any that follow it, will reduce the bonds’ carrying value. The reason for this is that the premium account balance gets decreased periodically.
The bonds’ carrying value will have been written down to $100k by the time they mature.
Below is a partial balance sheet as of 1 July 2020 and the related T accounts.