Accounting for bonds issued at a premium
To show how to account for bonds issued at a premium, we wül now assume that on January 2, 2020, the Valenzuela Corporation issues $100,000, 5-year, 12% term bonds. Interest is payable semiannually on January 2 and July 1. In this case, however, the bonds are issued when the prevailing market interest rate for such investments is 10%. The bonds, therefore, are issued at a premium to yield 10% and are sold at a price of 107,7212, or $107,722. The entry to record this bond issue is:
This entry is similar for recording bonds issued at a discount, except that a premium account is involved. Cash is debited for the entire proceeds, and Bonds Payable is credited for the bonds’ face amount. The difference, in this case, is a credit to the Premium Bonds account of $7,722. The Premium on Bonds Payable is called an adjunct account because it is added to the Bonds Payable account in determining the bonds’ carrying value. To illustrate the Valenzuela balance sheet prepared on January 2, 1986, immediately after the bonds were issued, shows the following under the long-term liability section:
Using Present Value to Determine Bond Prices
This section explains how the price of the bonds that were issued at a premium can be determined using present-value techniques. If you have not covered the present-value concept or your professor instructs you to do so, this section may be omitted with no loss of continuity.
Exhibit ‘A’ shows how the price of the Valenzuela Corporation’s 5-year 12% bonds issued to yield can be determined. The calculations in Exhibit ‘A’ are similar to those of the discount example in Exhibit ‘A’ in Accounting for bonds issued at a discount, except that the cash flows are discounted at the semiannual yield rate of 5%.
The Nature of the Premium Account
In effect, the premium should be thought of as a reduction in interest expense that should be amortized over the life of the bond. The bonds were issued at a premium because the stated interest rate was higher than the prevailing market rate. The bondholders arc receiving $6,000 ($100,000 x .06) every 6 months when comparable investments were yielding only 10% and paying $5,000 ($100,000 x .05) every 6 months. The premium of $7,722 represents the present value of that extra $1,000 difference that the bondholders will receive in each of the next 10 interest periods.
Because the bond is an attractive investment, its price is bid up to $107,722, and the premium of $7,722 is considered a reduction of interest expense. Although the borrower receives all of the funds at the time of the issue, the matching convention requires that it be recognized over the life of the bond.
After issuing the bonds at premium, the total interest expense incurred by the Valenzuela Corporation over the 5-year life of the bonds is $52,278, calculated as follows:
Again, another way to view this is to consider what the company will ultimately repay the bondholders versus what it received at the time of issuance. This calculation is shown below:
Amortizing tho Premium
The premium of $7,722 is amortized by using either the stralght=line method or the effective-interest method. Again the straight-line method will be discussed first, then the effective interest method will be discussed for both the discount and premium examples.
The Straight-line Method
Under the straight-line method, the premium of $7,722 is amortized over 10 interest periods at a rate of $772 ($7,722 / 10) per period. Thus the total Interest expense for each period is $5,228, consisting of the $6,000 cash interest less the premium amortization of $772. Another way to calculate the $5,228 is to divide the total interest cost of $52,278, as just calculated, into the 10 interest periods of the bond’s life. Exhibit ‘B’ presents an amortization schedule for this bond issue, on a straight-line basis. The journal entry at July 1, 2020, and each interest payment date thereafter is:
The effect of this and subsequent entries is to decrease the carrying value of the bonds as the premium account is reduced each period. By the time the bonds reach maturity, their carrying value will have been reduced to their face value of $100,000. The relevant T accounts and partial balance sheet as of July I, 2020 are presented next: