Question

When a bond sells at a premium, is the periodic interest expense less than, equal to, or greater than the periodic interest payment? Why? Be specific. State any accounting principles that must be invoked, and how that (those) principle(s) apply. What is the role of the premium account in your answer? Fully explain why as we practiced in class. Be concise, yet thorough in your explanation.

Answer 1

• Bonds issued at a premium When we issue a bond at a premium, we are selling the bond for more than it is worth.   We always record Bond Payable at the amount we have to pay back which is the face value or principal amount of the bond. The difference between the price we sell it and the amount we have to pay back is recorded in a liability account called Premium on Bonds Payable. Just like with a discount, we will remove the premium amount will be removed over the life of the bond by amortizing (which simply means dividing) it over the life of the bond. The premium will decrease bond interest expense when we record the semiannual /Annual interest payment

Accounting Principle :

In accounting, the effective interest method examines the relationship between an asset's book value and related interest. In lending, the effective annual interest rate might refer to an interest calculation wherein compounding occurs more than once a year. In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price

Example of Bonds issued at premium

• Assume Jan 1 Carr issues $100,000, 12% 3-year bonds for a price of 105 1/4 or 105.25% with interest to be paid semi-annually on June 30 and December 30 for cash. The entry to record the issue of the bond on January 1 would be:

  		Debit	Credit
  Jan 1	Cash ($100,000 x 105.25%)	105,250
  	Premium on Bonds Payable ($105,250 cash – $100,000 bond)		5,250
  	Bonds Payable ($100,000 bond amount)		100,000
  	To record issue of bond at a premium.

  The carrying value of these bonds at issuance is equal to the cash received of $105,250, consisting of the face value of $100,000 and the premium of $5,250. The premium is an adjunct account shown on the balance sheet as an addition to bonds payable as follows:

  Long-term Liabilities:
  Bonds Payable, 12% due in 3 years	$100,000
  Plus: Premium on Bonds Payable	5,250	$105,250

  Remember, when a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. A premium decreases the amount of interest expense we record semi-annually. In our example, the bond pays interest every 6 months on June 30 and December 31. We will amortize the premium using the straight-line method meaning we will take the total amount of the premium and divide by the total number of interest payments. In this example the premium amortization will be $5,250 discount amount / 6 interest payment (3 years x 2 interest payments each year). The entry to record the semi-annual interest payment and discount amortization would be:

  		Debit	Credit
  Jun 30	Bond Interest Expense ($6,000 cash interest – 875 premium amortization)	5,125
  	Premium on Bonds Payable ($5,250 premium / 6 interest payments)	875
  	Cash ($100,000 x 12% x 6 months / 12 months)		6,000
  	To record period interest payment and premium amortization.

  Just like with a discount, we would have completely amortized or removed the premium so the balance in the premium account would be zero. Our entry at maturity would be:

  		Debit	Credit
  Jan 1 (maturity)	Bonds Payable	100,000
  	Cash		100,000
  	Bonds Payable ($100,000 bond amount)		100,000
  	To record payment of bond at maturity.

• The price of a bond issue often differs from its face value.
• The amount a bond sells for above face value is a premium. The amount a bond sells for below face value is a discount.
• A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept.
• The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period.
• The market rate fluctuates from day to day, responding to factors such as the interest rate the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and demand for, money.
• Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate.

Market Rate = Contract Rate	Bond sells at par (or face or 100%)
Market Rate < Contract Rate	Bonds sells at premium (price greater than 100%)
Market Rate > Contract Rate	Bond sells at discount (price less than 100%)