Bonds Issued at premium | Financial Accounting | CPA & CMA Exam

In this video, we explain bonds issued at premium.
Start your free trial: farhatlectures...
Understanding Bonds Issued at a Premium
When a bond is issued at a premium, it means the bond is sold for more than its face (or par) value. This typically occurs when the coupon rate (the interest rate the bond pays) is higher than the prevailing market interest rates. Investors are willing to pay extra for a bond that yields an interest rate higher than what other similar investments are currently offering.
1. Basics of Bond Pricing
Face Value: The nominal amount of the bond that the issuer agrees to pay the bondholder at maturity, usually set at $1,000 per bond.
Coupon Rate: The annual interest rate paid on a bond's face value by the bond issuer.
Market Rate: Also known as the yield or effective interest rate, this is the rate of return that investors demand for bond investments of similar risk.
A bond's price is determined by the present value of its expected future cash flows, which are the periodic interest payments and the principal amount to be repaid at maturity. If the bond's coupon rate is above the current market rate, its cash flows are valued more highly, leading to a price above par value, or a premium.
2. Accounting for Bonds Issued at a Premium
When bonds are issued at a premium, the issuer receives more cash than the face value of the bonds. The premium (the excess amount over face value) is initially recorded as a credit balance in a separate account, typically "Premium on Bonds Payable." This premium is effectively a reduction to the cost of borrowing over the life of the bond and is amortized into income, reducing the amount of interest expense recorded each period.
Journal Entries at Issuance:
Cash (Dr.)
Bonds Payable (Cr.)
Premium on Bonds Payable (Cr.)
The Premium on Bonds Payable represents the additional amount paid by investors over and above the bond's face value. It is credited because it is a liability account that will be amortized over the life of the bond.
3. Amortization of the Bond Premium
The amortization of the bond premium decreases the interest expense reported on the income statement over the bond's term.
Straight-Line Method: This method evenly spreads the premium amount as a reduction in interest expense over the bond's life.
Effective Interest Rate Method: This method, preferred under GAAP, uses a variable amount each period, based on the carrying value of the bond and the market rate at issuance.
Journal Entry for Amortization (Yearly or Semi-annually):
Interest Expense (Dr.)
Premium on Bonds Payable (Cr.)
Cash (Cr.)
Here, the amount debited to the Premium on Bonds Payable reduces the balance of the premium, and the credit to Interest Expense reduces the total interest expense recognized.
4. Impact on Financial Statements
Income Statement: Lower interest expense due to the amortization of the premium.
Balance Sheet: Initially, the bond is recorded at its issue price (including the premium). Over time, the carrying amount of the bond decreases to its face value as the premium is amortized.
Cash Flows: The interest paid (cash flow) is greater than the interest expense shown on the income statement due to the amortization of the premium.
5. Example Calculation
Suppose a company issues a $100,000 bond, due in five years, with a coupon rate of 6% when the market rate is 5%. The bond would be issued at a premium to reflect the higher interest payments compared to the market rate. The specific premium amount would be determined by calculating the present value of $100,000 due in five years plus the present value of the annual interest payments ($6,000), discounted at the market rate of 5%.
Conclusion
Bonds issued at a premium provide an interesting case for financial analysis, affecting both the issuer’s cash flows and interest expense recognition. Properly accounting for these premiums helps ensure that the financial statements accurately reflect the company’s financing costs and obligations. Understanding this process is crucial for investors, accountants, and financial analysts dealing with corporate bonds.
#accountingstudents #cpaexaminindia #cpaexam

[@tonysyoutube542]

Great lecture professor farhat. I love your review course as a supplement to Becker. Great stud.

[@AccountingLectures]

Thank You. Please check my FAR Becker supplemental course: farhatlectures.com/courses/far-becker-supplemental-course-2024/

[@VandeRij-d3k]

hi you didn't respond to the chat on your website. I'm wondering if your admin is taking messgaes..