Premium on bonds payable, an account payable, is a difference between the face amount of bonds payable and the price paid when initially issued. Bonds may be sold at a discount or a premium. Issuing bonds at a premium decreases interest expense and increases the carrying value of the bond liability.
Best Structure for Premium on Bonds Payable
When a company issues bonds at a price greater than their face value, the difference is called a premium. This premium is amortized over the life of the bonds and reduces the carrying value of the bonds. There are two methods for amortizing the premium: the straight-line method and the effective-interest method.
Straight-Line Method
The straight-line method of amortization allocates the premium evenly over the life of the bonds. This is the simplest method to use and results in a constant amount of amortization expense each period.
For example, if a company issues $1,000,000 of bonds with a face value of $1,000,000 and a premium of $20,000, the annual amortization expense would be $2,000 ($20,000 / 10 years).
Effective-Interest Method
The effective-interest method of amortization allocates the premium based on the effective interest rate of the bonds. This method results in a decreasing amount of amortization expense each period as the carrying value of the bonds decreases.
To calculate the amortization expense using the effective-interest method, the following formula is used:
Amortization Expense = Carrying Value of Bonds * Effective Interest Rate
For example, if the company in the previous example has a bond issue with an effective interest rate of 5%, the amortization expense for the first year would be $50,000 ($1,020,000 * 5%).
Comparison of Methods
The following table compares the straight-line method and the effective-interest method of amortizing bond premiums:
| Method | Amortization Expense | Carrying Value of Bonds |
|---|---|---|
| Straight-Line | Constant | Decreasing |
| Effective-Interest | Decreasing | Constant |
Which Method is Best?
The best method of amortizing bond premiums depends on the company’s circumstances. The straight-line method is simpler to use and results in a constant amount of amortization expense. The effective-interest method is more accurate but results in a decreasing amount of amortization expense.
Question 1:
What is the concept of premium on bonds payable?
Answer:
Premium on bonds payable is the additional amount a company pays above the face value of its bonds when issuing them. This excess payment increases the bond’s market value and interest rate. The company amortizes the premium over the life of the bonds, reducing the interest expense and increasing the book value.
Question 2:
How does premium on bonds payable affect financial statements?
Answer:
Premium on bonds payable impacts financial statements by reducing the interest expense on the income statement and increasing the bond’s carrying value on the balance sheet. The premium is amortized as an expense over the bond’s term, resulting in lower interest expense. Simultaneously, the bond’s carrying value increases gradually, reflecting its premium.
Question 3:
What are the implications of issuing bonds at a premium for a company?
Answer:
Issuing bonds at a premium provides several benefits for a company. It reduces the company’s borrowing costs by lowering interest payments. Additionally, it enhances the bond’s market value and attractiveness to investors. The premium increases the bond’s yield-to-maturity, making it more desirable in the secondary market.
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