Each bond issuance has a credit rating assigned to it by independent rating agencies such as Standard & Poor’s Corporation. Essentially, the higher the rating (AAA or investment-grade bonds), the more access the company has to investors’ capital at a reasonable interest rate. Conversely, the lower the rating (CCC/C or junk bonds), the higher the risk and interest rate to be paid. Since the rating assigned is a function of company performance, this rating can change over the lifespan of the bond issue. One simple way to understand bonds issued at a premium is to view the accounting relative to counting money!

At maturity, the amount paid to the bondholders is the face value (or par value) amount, which is also the fair value on that date. The bond market is efficient and matches the current price of the bond to reflect whether current interest rates are higher or lower than the bond’s coupon rate. It’s important for investors to know why a bond is trading for a premium—whether it’s because of market interest rates or the underlying company’s credit rating. In other words, if the premium is so high, it might be worth the added yield as compared to the overall market.

Intermediate Financial Accounting 2

In this case, however, the bonds are issued when the prevailing market interest rate for such investments is 10%. Companies that follow ASPE can choose to use the simpler straight-line interest method. The discount of $32,520 () would be amortized on a straight-line basis over the 10 years.

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. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.

Bond Premiums and Interest Rates

The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable. https://simple-accounting.org/the-amortization-of-premium-on-bonds-payable/ As explained earlier in this chapter regarding notes payable, the market rate (effective rate or yield) is not always the same as the stated or face rate. When these two interest rates are different, each one is used to determine certain cash flows required to calculate the present value.

Amortize the premium or discount using the straight-line amortization method. The premium on bonds payable is known as the excess amount over the face value of the bond. The bond is issued at a premium in order to create an immediate capital gain for the issuer. The company typically chooses to issue the bond when it has exhausted most or all of its current sources of financing, but still needs additional funds in the short run. Suppose that on 2 January 2020, Valenzuela Corporation issued $100,000, 5-year, 12% term bonds.

What Is a Premium Bond? Definition, How It Works, and Yield

See Table 2 for interest expense and carrying values over the life of the bond calculated using the effective interest method of amortization . At the time, the market rate is lower than 8%, so investors pay $1,100 for the bond, rather than its $1,000 face value. The excess $100 is classified as a premium on bonds payable, and is amortized to expense over the remaining 10 year life span of the bond. At that time, https://simple-accounting.org/ 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. Thus, bonds payable appear on the liability side of the company’s balance sheet. Amortization of premium on bonds payable is the process of gradually reducing the premium on bonds payable over the bond’s life until the bond’s carrying value equals its face value at maturity.

For 20X1, interest expense can be seen to be roughly 5.8% of the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4, interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412). The content provided on accountingsuperpowers.com and accompanying courses is intended for educational and informational purposes only to help business owners understand general accounting issues.

Amortization of Discount on Bonds Payable

The accounting for bonds purchased at a premium follows the same method as was illustrated for bonds at a discount. The illustration will be changed slightly to introduce the use of the market spot rate. The term bonds issued at a premium refers to newly issued debt that is sold at a price in excess of its par value. When a bond is issued at a premium, the company will typically choose to amortize the premium paid over the term of the bond using a straight line method.

• Bond issuers fix this problem by adjusting the issue price of the bond, so the actual interest paid on the bond equals the market rate.
• When the company issues bonds and the issuer of bonds record the face value of bonds, which means bonds are issued at par.
• As an example let’s say that Apple Inc. (AAPL) issued a bond with a $1,000 face value with a 10-year maturity.
• If the issuer records the bonds at more than their face value, bonds are issued at a premium.
• This makes intuitive sense given that the bonds have only been held for two months making interest for two months the correct amount.