Ch14 Long Term Liabilities Handout-3 Premiums

1 Premiums
When the contact rate exceeds the market rate, the result is a premium
Effects of a Premium: - Increases the cash received by the company
- Decreases the bond interest expense

Treatment in Balance Sheet:

Example: P1 million bond sold at 105
Bonds Payable 1,000,000
Plus: Premium on Bonds Payable 50,000
Carrying Value 1,050,000

1.1 Basic Journal Entries

Example: P1 million bond sold at 105
BOND ISSUANCE
ISSUERS POV BUYERS POV
Dr. Cash 1,050,000 Dr. Investment in Bonds 1,050,000
Dr. Premium on Bonds 50,000 Cr. Cash 1,050,000
Cr. Bonds Payable 1,000,000
(Please note this difference. In all other entries, the buyers POV is simply reversed. In this case, the buyers investment
in bonds is always at the carrying value)

1.2 Amortization
The premium is considered a reduction to interest expense. Like the discount, it must also be distributed across
each period.
Bond Interest Paid refers to the amount of interest to be paid in cash (Face Value X Coupon rate / Number of
Payments per Year)
Bond Interest Expense refers to the total amount of bond interest, which must include the premium. Bond
Interest Paid - premium.

How to Compute:
Example: P1 million bond sold at 105. Interest payment is twice a year for 4 years at 5%.
Eight Interest Payments (25,000 X 8) 200,000 (Bond Interest Paid)
Less: Premium (50,000)
Bond Interest Expense 150,000 (This is for the entire 4 years)
Or

Principal 1,000,000
Plus: Interest Payments 200,000
Less: Proceeds from Bond Sale (1,050,000)
Bond Interest Expense 150,000

This means that a total of 400,000 in interest paid and 50,000 in premiums must be distributed or amortized across the
eight payment periods.

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Ch14 Long Term Liabilities Handout-3 Premiums
1.2.1 Straight Line Method
The amount of bond interest paid and the amount of premium amortized across each period is constant.
Computation:
Total Interest Expense / Number of Periods = Interest Expense per Period

Using the same example above:

150,000 / 8 periods = 18,750
Out of bond interest of 18,750 per 6 months, 25,000 will be the bond interest paid and 6,250 will be the amortized
premium every 6 months.

Amortization Table: Straight Line Method

A B C D E
Period Cash Interest Paid Interest Expense Premium Amortized Unamortized Premium Carrying Value
Beg.
1
2
3
4
5
6
7
8
*Each period = 6 months
A = Face Value X Coupon Rate / Number of Payments per Year
B = Total Interest Expense / Number of Periods
C=AB
D = Updated amount of premium remaining
E = Face Value + D

Recording Interest Payment:

ISSUERS POV
Dr. Bond Interest Expense 18,750
Dr. Premium on Bonds 6,250
Cr. Cash 25,000
(Premium is originally a credit entry, that means this entry decreases the premium, and increases the carrying value.
We are distributing the premium as a reduction to interest expense by P6,250 per period)

BUYERS POV
Dr. Cash 25,000
Cr. Investment in Bonds 6,250
Cr. Bond Interest Revenue 18,750
(This decreases the Investment In Bonds account of the buyer. The carrying value for the issuer and the buyer should be
the same)

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Ch14 Long Term Liabilities Handout-3 Premiums

If Interest Payment occurs in between two periods:

Recognized accrued interest for both the cash to be paid and the premium

Example: The company pays interest every Nov 1 and May 1. The company adjusts its books every Dec 31.
ISSUERS POV BUYERS POV
12/31 Dr. Bond interest expense (18,750x 2/6) 6,250 Dr. Interest receivable 8,333
Dr. Premium on bonds (6,250x 2/6) 2,083 Cr. Investment in bonds 6,250
Cr. Interest payable (25,000x 2/6) 8,333 Cr. Interest revenue 2,083
5/1 Dr. Interest payable 8,333 Dr. Cash 25,000
Dr. Interest expense (18,750x 4/6) 12,500 Cr. Interest revenue 12,500
Dr. Premium on bonds (6,250x 4/6) 4,167 Cr. Interest receivable 8,333
Cr. Cash 25,000 Cr. Investment in bonds 4,167

1.2.2 Effective Interest Method

Allocates interest expense such that the interest yields a constant rate, which is called the Effective Interest Rate.

Example: A 10% P1,000,000, 3 year bond is issued on May 1 at 105.24. Interest is paid every May 1 and November 1.
Books are adjusted every December 31. The current market rate is 8%

Effective Interest Rate = 8% per annum or 4% every 6 months

A B C D E
Period Cash Interest Paid Interest Expense Premium Amortized Unamortized Premium Carrying Value
Beg

*Due to rounding error, we are left with a small amount of unamortized premium but this should be very close to zero.
*For the last period, we will solve for the amortized premium manually, to ensure that premium is fully amortized.

A = Face Value X Coupon Rate / Number of Payments per Year

B = Carrying Value X Market Rate / Number of Payments per Year (in this case 1,052,400 X .04 for the first period)
C=AB
D = Updated amount of premium remaining
E = Face Value + D

The journal entries are the same as the straight line method. The only change will be in the amount of interest expense
and premium amortized.

Important: Remember that if there is a discount, interest expense > cash interest paid
If there is a premium, interest expense < cash interest paid
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