Learn about Issuing Bonds at a Premium

Issuing Bonds at a Premium

P3 Compute and record amortization of bond premium.

When the contract rate of bonds is higher than the market rate, the bonds sell at a price higher than par value. The amount by which the bond price exceeds par value is the premium on bonds Difference between a bond’s par value and its higher carrying value; occurs when the contract rate is higher than the market rate; also called bond premium.. To illustrate, assume that Adidas issues bonds with a $100,000 par value, a 12% annual contract rate, semiannual interest payments, and a two-year life. Also assume that the market rate for Adidas bonds is 10% on the issue date. The Adidas bonds will sell at a premium because the contract rate is higher than the market rate. The issue price for these bonds is stated as 103.546 (implying 103.546% of par value, or $103,546); we show how to compute this issue price later in the chapter. These bonds obligate the issuer to pay out two separate future cash flows:

1. Par value of $100,000 cash at the end of the bonds’ two-year life.
2. Cash interest payments of $6,000 (6% × $100,000) at the end of each semiannual period during the bonds’ two-year life.

The exact pattern of cash flows for the Adidas bonds is shown in Exhibit 14.8.

EXHIBIT 14.8 Cash Flows for Adidas Bonds

When Adidas accepts $103,546 cash for its bonds on the issue date of December 31, 2011, it records this transaction as follows.



 

These bonds are reported in the long-term liability section of the issuer’s December 31, 2011, balance sheet as shown in Exhibit 14.9. A premium is added to par value to yield the carrying (book) value of bonds. Premium on Bonds Payable is an adjunct (also called accretion) liability account.

EXHIBIT 14.9 Balance Sheet Presentation of Bond Premium

Amortizing a Bond Premium Adidas receives $103,546 for its bonds; in return, it pays bondholders $100,000 after two years (plus semiannual interest payments). The $3,546 premium not repaid to issuer’s bondholders at maturity goes to reduce the issuer’s expense of using the $103,546 for two years. The upper portion of panel A of Exhibit 14.10 shows that total bond interest expense of $20,454 is the difference between the total amount repaid to bondholders ($124,000) and the amount borrowed from bondholders ($103,546). Alternatively, we can compute total bond interest expense as the sum of the four interest payments less the bond premium. The premium is subtracted because it will not be paid to bondholders when the bonds mature; see the lower portion of panel A. Total bond interest expense must be allocated over the four semiannual periods using the straight-line method (or the effective interest method in Appendix 14B).
 

EXHIBIT 14.10 Interest Computation and Entry for Bonds Issued at a Premium

Straight-Line Method The straight-line method allocates an equal portion of total bond interest expense to each of the bonds’ semiannual interest periods. To apply this method to Adidas bonds, we divide the two years’ total bond interest expense of $20,454 by 4 (the number of semiannual periods in the bonds’ life). This gives a total bond interest expense of $5,113 per period, which is $5,113.5 rounded down so that the journal entry balances and for simplicity in presentation (alternatively, one could carry cents). Panel B of Exhibit 14.10 shows how the issuer records bond interest expense and updates the balance of the bond liability account for each semiannual period (June 30, 2012, through December 31, 2013).

Point: A premium decreases Bond Interest Expense; a discount increases it.

EXHIBIT 14.11 Straight-Line Amortization of Bond Premium * Total bond premium (of $3,546) less accumulated periodic amortization ($887 per semiannual interest period). † Bond par value (of $100,000) plus unamortized premium. ‡ Adjusted for rounding.

Exhibit 14.11 shows the pattern of decreases in the unamortized Premium on Bonds Payable account and in the bonds’ carrying value. The following points summarize straight-line amortization of the premium bonds:

1. At issuance, the $100,000 par value plus the $3,546 premium equals the $103,546 cash received by the issuer.
2. During the bonds’ life, the (unamortized) premium decreases each period by the $887 amortization ($3,546/4), and the carrying value decreases each period by the same $887.
3. At maturity, the unamortized premium equals zero, and the carrying value equals the $100,000 par value that the issuer pays the holder.