Premium on bonds payable is the excess of the amount a company receives when it issues bonds over the face value of those bonds. A bond sells at a premium when its stated interest rate, the coupon rate, is higher than the market interest rate investors require for bonds of similar risk and maturity. Investors are willing to pay more than face value for the higher interest payments, which brings their effective return down to the market rate. It is often called simply a bond premium.
In the accounts, the premium is recorded in a separate account that is added to bonds payable on the balance sheet, making it an adjunct account. Over the life of the bonds, the premium is gradually reduced, which lowers interest expense below the cash interest paid. The detailed calculation of that reduction is covered in the entry on amortization of bond premium; this entry focuses on the premium account itself and why it exists. The opposite case, where bonds are issued below face value, is a discount on bonds payable.
A bond's price equals the present value of its future cash flows, its interest payments and the face value at maturity, discounted at the market rate. If the market rate falls below the coupon rate between the time the bond terms are set and the issue date, or if a company deliberately sets a high coupon, the present value exceeds the face value. The premium therefore reflects the value of the above-market interest stream.
Worked example
A company issues $1,000,000 of five-year bonds with an 8 percent coupon paid annually, when the market rate is 6 percent. The issue price is:
- is the annual coupon payment, here $80,000.
- is the market interest rate, here 0.06.
- is the number of periods, here 5.
- is the face value, $1,000,000.
The coupons are worth $80,000 times 4.21236, or about $336,989, and the face value is worth about $747,258, so the bonds sell for about $1,084,247. The journal entry debits cash $1,084,247, credits bonds payable $1,000,000 and credits premium on bonds payable $84,247.
Under the effective interest rate method, interest expense in year one is 6 percent of the carrying amount of $1,084,247, or $65,055. The company pays $80,000 in cash, so the premium is reduced by $14,945, and the carrying amount falls to $1,069,302. In year two, interest expense is $64,158 and the premium falls by $15,842. By maturity, the premium is zero and the carrying amount equals the $1,000,000 face value that is repaid.
On the balance sheet, the bonds appear at their carrying amount: face value plus unamortized premium. In the example, the liability at the end of year one is $1,069,302. Under both US GAAP and IFRS, debt is measured at amortized cost using the effective interest method; US GAAP permits the simpler straight-line method only if the result is not materially different. Debt issue costs are deducted from the carrying amount, so they partly offset a premium. Total interest expense over the bond's life equals the coupons paid, $400,000, minus the premium of $84,247, or $315,753.
If a company redeems bonds early, for example by exercising a call option on a callable bond, it removes the face value and the unamortized premium and recognizes a gain or loss for the difference between that carrying amount and the price paid, including any call premium. A common error is to treat the premium as income when the bonds are issued; it is part of the liability and only reduces interest expense gradually. Readers should also note that the coupon rate, set out in the bond indenture, determines cash payments, while the market rate at issue determines reported expense.