Amortization of premium on bonds payable

The table starts with the book value of the bond which is the par value (120,000) less the discount on bonds payable (2,152), which equals the amount of cash received from the bond issue (117,848). The table starts with the book value of the bond which is the par value (120,000) plus the premium on bonds payable (2,204), which equals the amount of cash received from the bond issue (122,204). If bonds payable are issued by a business at a value other than their par value a premium or discount on bonds payable is created in the accounting records of the business.

In the case of the 9% $100,000 bond issued for $104,100 and maturing in 5 years, the annual straight-line amortization of the bond premium will be $820 ($4,100 divided by 5 years). The interest expense is amortized over the twenty periods during which interest is paid. Amortization of the discount may be done using the straight‐line or the effective interest method. Currently, generally accepted accounting principles require use of the effective interest method of amortization unless the results under the two methods are not significantly different. If the amounts of interest expense are similar under the two methods, the straight‐line method may be used.

Past or Future Value

Note that under the effective interest rate method the interest expense for each year is increasing as the book value of the bond increases. Under the straight-line method the interest expense remains at a constant amount even though the book value of the bond is increasing. The accounting profession prefers the effective interest rate method, but allows the straight-line method when the amount of bond discount is not significant. Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0.

The bonds have a term of five years, so that is the period over which ABC must amortize the discount. From the bond amortization schedule, we can see that at the end of period 4, the ending book value of the bond is reduced to 120,000, and the premium how to calculate premium on bonds payable on bonds payable (2,204) has been amortized to interest expense. The final bond accounting journal would be to repay the par value of the bond with cash. The carrying value will continue to increase as the discount balance decreases with amortization.

Straight Line Bond Amortization

Notice that under both methods of amortization, the book value at the time the bonds were issued ($96,149) moves toward the bond’s maturity value of $100,000. The reason is that the bond discount of $3,851 is being reduced to $0 as the bond discount is amortized to interest expense. To calculate interest expense for the next semiannual payment, we subtract the amount of amortization from the bond’s carrying value and multiply the new carrying value by half the yield to maturity. To calculate interest expense for the next semiannual payment, we add the amount of amortization to the bond’s carrying value and multiply the new carrying value by half the yield to maturity. The format of the journal entry for amortization of the bond premium is the same under either method of amortization – only the amounts change.

• Initially it is the difference between the cash received and the maturity value of the bond.
• The straight line bond amortization method simply involves calculating the total premium or discount on the bonds and then amortizing this to the interest expense account in equal amounts over the lifetime of the bond.
• Discount amortizations are likely to be reviewed by a company’s auditors, and so should be carefully documented.
• This means the interest rates issued and printed on the bonds aren’t the same as the current market rates.
• As before, the final bond accounting journal would be to repay the face value of the bond with cash.

In our example, the bond premium of $4,100 must be reduced to $0 during the bond’s 5-year life. By reducing the bond premium to $0, the bond’s book value will be decreasing from $104,100 on January 1, 2022 to $100,000 when the bonds mature on December 31, 2026. Reducing the bond premium in a logical and systematic manner is referred to as amortization. If a bond is issued at a given rate and then prevailing interest rates in the bond market fall, then the higher-interest bond looks better than it did previously. Each period the interest expense (5,338) is the interest paid to the bondholders based on the par value of the bond at the bond rate (4,800) plus the discount amortized (538).

What is the Amortization of Premium on Bonds Payable?

Suppose, for example, a business issued 8% 2-year bonds payable with a par value of 120,000 and semi-annual payments, in return for cash of 117,848 representing a market rate of 9%. Suppose, for example, a business issued 8% 2-year bonds payable with a par value of 120,000 and semi-annual payments, in return for cash of 122,204 representing a market rate of 7%. The straight line bond amortization method simply involves calculating the total premium or discount on the bonds and then amortizing this to the interest expense account in equal amounts over the lifetime of the bond. The straight line amortization method is one method of calculating how the premium or discount on bonds payable should be amortized to the interest expense account over the lifetime of the bond.

This means that when a bond’s book value decreases, the amount of interest expense will decrease. In short, the effective interest rate method is more logical than the straight-line method of amortizing bond premium. This method is a more accurate amortization technique, but also calls for a more complicated calculation, since the amount charged to expense changes in each accounting period. This method is required for the amortization of larger discounts, since using the straight-line method would materially skew a company’s results to recognize too little interest expense in the early years and too much expense in later years.

When a bond is sold at a premium, the amount of the bond premium must be amortized to interest expense over the life of the bond. In other words, the credit balance in the account Premium on Bonds Payable must be moved to the account Interest Expense thereby reducing interest expense in each of the accounting periods that the bond is outstanding. A premium occurs when the market interest rate is less than the stated interest rate on a bond. In this case, investors are willing to pay extra for the bond, which creates a premium.

Unlike notes payable, which normally represent an amount owed to one lender, a large number of bonds are normally issued at the same time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior to their maturity. The preferred method for amortizing the bond premium is the effective interest rate method or the effective interest method. Under the effective interest rate method the amount of interest expense in a given year will correlate with the amount of the bond’s book value.

Example of the Amortization of a Bond Premium

At maturity, the entry to record the principal payment is shown in the General Journal entry that follows Table 1. 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. The premium arises when the bonds are issued at a price higher than their face value due to a lower market interest rate than the stated interest rate on the bond. Notice that the effect of this journal is to post the interest calculated in the bond amortization schedule (5,338) to the interest expense account. In effect, because the bonds were issued at a discount and the business received less cash than the par value of the bonds, the cost (interest) to the business is increased each period by the amount of the bond discount amortization.