Following on from our article that looked at the discount side, in today’s accounting tutorial series we look at the journal entry and calculations required when a premium on a bonds payable issue is paid. In particular, we will look at how a premium arises, how it is calculated, the journal entries and how to amortise the premium over the life of the bond. We will also look at the journal entry for the repayment of the bond at maturity.
For those in a hurry the quick answer, ignoring amortisation of the premium etc, is to raise a debit to the premium on bonds payable account, while a credit is applied to the interest expense account. If you would like to know some more detail of what is behind all of this … please read on.
What is a Bond?
A bond is just a promise to pay another party two things; one, a set rate of interest on specific dates; and two, repay them their principal on maturity. Bonds don’t normally have early repayment options for holders, although of course the bond can normally be sold onto another buyer – with no involvement from the issuer.
Like any other liability on the balance sheet (statement of financial position), a bond is normally classified as non-current as they tend to be issued on five to ten-year maturities. Of course, this is apart from the year before maturity where that classification would change to current.
Bonds are best known as being issued by companies and central governments, however, not-for-profit organisations also use them for their debt funding requirements. The most famous types of bond issues are the United States Treasury Bills (or T-Bills) and the British Gilts issued by HM Treasury Debt Management Office.
There are three key characteristics that are important to know for accounting about bonds payable:
- the interest payable on the bonds is called the coupon rate. The bond will set out the percentage, how it is to be compounded and when it is to be paid;
- as mentioned above, the bond will have a set maturity date for repayment; and
- once issued on the primary market a bond can be freely traded through a secondary market, with the original purchaser not having to hold until maturity. For example, the Gilts issued by HM Treasury Debt Management Office are traded on the London Stock Exchange.
What is a Premium on Bonds Payable?
A premium on a bonds issue arises when the interest rate being paid on the bond, referred to as the coupon rate, is higher than the equivalent market interest rate at the moment. Like the discount situation we looked at in our other article, this raises three issues we need to look at. First, why would a firm be paying above market interest rates? Second, how is the premium, which is a percentage, converted into a dollar value so we can create the correct journal entry? And third, what type of account is the premium account and where is it disclosed in the financial accounts?
How do Premiums Arise?
As we mentioned above, when the coupon rate is above the prevailing equivalent interest rate a bond is being issued at a premium to bond holders. The bond holders are willing to pay a premium because the interest rate they will receive, the coupon rate, is higher than is being paid in the market at that point. This is more typical in an environment of falling interest rates, as apposed to the discount situation that arises in a rising interest rate environment.
Of course the premium may also be necessary to encourage investors to take up the bond issue due to perhaps the firm issuing the bonds being perceived to having a higher credit risk than similar, perhaps more established, firms in the market.
Bonds Payable Premium Calculations
The next thing we need to understand is how to calculate the premium on the bond issue. We’ll cover the formula before using it in an example with journal entries below.
To see how the formula works, we’ll say ABC Ltd has decided to issue 5 year, $5,000 bonds and paying 7 per cent (payable every six months). The prevailing market interest rate is 5 per cent. The formula to calculate a bond price is:
Bond price = Principal / (1 + i) n + Interest x ((1 – 1 / (1 + i)n ) / i)
- principal = face value of the bond
- interest = interest amount per payable period
- i = the market interest rate
- n = number of interest payable periods over the life of the bond
In our example the bond price is:
- principal = $5,000
- interest = ($5,000 x 7%) / 2 = $175 per payable period
- i = 5% per annum (market rate)
- n = 5 years x 2 quarters per annum = 10 payable periods.
Bond price = $5,000 / (1 + 5% / 2)10 + $175 x ((1 – 1 / (1 + 5%)10 / (5% / 2))
Bond Price = $5,438
So our formula calculates that bondholders will be willing to pay $5,438 for face value bonds of $5,000; providing ABC Ltd a premium on issue of $438 per bond. This premium is generated by the difference between the coupon rate of 7 per cent and the market rate of 5 per cent.
Type of Account
An important concept to understand with the premium account is that it is an adjunct account. What this means is it is attached to another account with the same natural balance, ie a debit or credit. In our case it is attached to the Bonds Payable account, which has a natural credit balance, and so this means the premium account also has a natural credit balance. So as we’ll see below, this will obviously mean the premium account will be increased by a credit entry and decreased by debit entries.
Journal Entry for Premium on Bonds Payable
Now to the fun bit, the debits and credits. We will look at four sections relating to a bond issue:
- cash is received and bonds are issued:
- first interest payment is paid to bond holders;
- premium paid by bond holders is amortised; and
- bonds are repaid at maturity.
The example we will use is ABC Ltd and the debt funding it wishes to raise to purchase more warehouse space. ABC will be raising $2,000,000, with the following bond details:
- bonds have a face value (or par value) of $20,000 each;
- the coupon rate is 7 per cent, paid out every six months;
- bonds will be issued on October 1 and mature on September 30 ten years hence; and
- the prevailing market interest rate is 5 per cent.
Cash is Received and Bonds are Issued
Because the coupon rate is higher than the prevailing market rate, bond purchasers are prepared to pay a premium to ABC Ltd for their debt. The formula we used above is:
Bond price = Principal / (1 + i) n + Interest x ((1 – 1 / (1 + i)n ) / i)
- principal = face value of the bond
- interest = interest amount per payable period
- i = the market interest rate
- n = number of interest payable periods over the life of the bond
The bond price for ABC Ltd debt will be:
- principal = $20,000
- interest = ($20,000 x 7%) / 2 = $700
- i = 5% (market interest rate)
- n = 10 years x 2 payments per year = 20 payable periods
Bond price = $20,000 / (1 + 5% / 2)20 + $700 x ((1 – 1 / (1 + 5%)20 / (5% / 2))
Bond Price = $23,118
Now we know what the price is per $20,000 par value bond to be issued, but we still have to work out how many bonds will have to be issued for the $2,000,000 ABC Ltd wants to raise. To do this, the following formula is used:
Funds to be raised / funds raised by bond
Which for our ABC example will be:
$2,000,000 / $23,118 = 87 (0 dp) bonds
So we have all the information we need to put together the journal entry for the receipt of bondholders money and issuing them the bond payables.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Oct 1 | Bank | 2,011,251 | |
| Premium on Bonds Payable Issue | 271,251 | ||
| Bonds Payable | 1,740,000 |
The bank debit entry reflects the $2,011,251 raised from the issue. While the credit of $1,740,000 (87 bonds x par value of $20,000) recognises the par value liability owed to bondholders on maturity. And the credit journal entry of $271,251 ($2,011,251 – $1,740,000) to the premium on bonds payable account reflects the additional funding cost that ABC is paying above market price and which we will amortise over the next ten years. There are rounding variances in these figures of course.
First Interest Payment to Bond Holders
Six months later and ABC Ltd has its first interest payment to make on the bonds. This payment is the coupon rate of 7 per cent. So on March 31 the accounts team at ABC would prepare the following calculation and journal entry:
$20,000 par value x 87 bonds x (7% coupon rate / 2) = $60,900
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| March 31 | Interest Expense | 60,900 | |
| Bank | 60,900 |
The debit reflects the increase in interest expense ABC incurs due to the bonds being on issue. And the credit to bank recognises the payment to bond holders at their coupon rate of 7 per cent.
Amortisation of Bond Premium
In addition to the six-monthly interest payments the premium on bonds payable is required to be amortised over the the ten year life of the instrument. The purpose of the amortisation is to provide a better reflection of the borrowing costs incurred by ABC for this debt funding. Because of the cash received compared to the liability taken on, the premium, difference between the market rate and the coupon rate, in affect off-sets the interest being paid at the higher rate of 7 per cent.
So what we need to do over the life of the debt is to amortise the premium in line with the six-monthly interest payments, to bring to account a better reflection of the interest costs to ABC Ltd.
To achieve this we have the choice of two main methods, the straight-line method and the effective interest method. Over the period of the bond they achieve the same result, ie the premium is fully amortised (bringing the balance to $0 at maturity). However, as we will see, over the life of the bond the profit and loss statement (statement of financial performance) will disclose potentially material differences in the interest expense each year.
We’ll start with the straight-line method, easier of the two.
The Straight-Line Method
Just as we would see say in the straight-line method in the depreciation of a fixed asset, the amount of premium amortised each interest period, and therefore each year, is the same. Once the first journal entry is prepared for the premium on bonds payable it can just be repeated each period until maturity.
The simple formula to be used is:
Bond Premium / number of interest payment periods
So for ABC this will be:
$271,251 / (10 years x 2 payments per annum) = $13,563 (0 dp)
With this information we can produce the six-monthly amortisation journal for the bonds payable premium for March 31 as:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| March 31 | Premium on Bonds Payable | 13,563 | |
| Interest Expense | 13,563 |
The debit of $13,563 in the journal entry decreases the premium on bonds payable premium adjunct account balance. While the credit to interest decreases this expense line. Although not normally a good idea, this off-set entry produces a better reflection of the interest expense incurred by ABC for the period.
For the financial year ended say March 31 for ABC, assuming no other interest entries or adjustments, we would see in the profit and loss statement a net interest expense of $47,337 ($60,900 – $13,563). And for the end of the following financial year we would see a net interest expense of $94,675 ($121,800 – $27,125). This of course being double compared to the first financial year as we have a full 12 months of interest expense and premium amortisation.
We’ll come back to these net interest expense figures once we have looked at the effective interest method – this will highlight the differences the two methods produce.
The Effective Interest Method
As we mentioned in our discount on bonds accounting tutorial, we have a whole article dedicated to the effective interest method and the detail behind it; that article can be found here.
Set out below is the calculation required to work out what the effective interest expense is for ABC Ltd for each interest payment period. It can look a little daunting, but not to worry. Below the table in the notes there is a explanation of what each column does.
Notes:
- Interest Periods: 10 years x 2 payments per year;
- Interest Payment: ($1,740,000 (Bonds Payable) x 7% (coupon rate))/ 2 = $60,900 per six months;
- Market Interest: Bond Book Value x market interest rate (5%);
- Premium Amortisation: Market Interest – Interest Payment;
- Unamortised Premium: Unamortised Balance previous year – this year’s Premium Amortisation; and
- Bond Book Value: Bond Book Value previous year – this year’s Premium Amortisation.
We already know which account to debit and credit as per the straight-line method we covered above, however, the figures is what we now need to change. For the debit part of the journal entry for the bonds payable premium, $10,619 is recorded. While the credit to interest now reduces this expense by $10,619.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| March 31 | Premium on Bonds Payable | 10,619 | |
| Interest Expense | 10,619 |
If you were to compare this to the straight-line method, ABC is amortising $2,944 less in the first interest payment period ($13,563 – $10,619). Therefore in the full second financial year ABC will disclose an interest expense of $100,563, compared to the straight-line method where the net interest expense figure was $94,675. All else being equal, ABC’s profit for the second financial year would be $5,888 higher.
At these amounts perhaps the difference isn’t material for the readers of the financial accounts. But it does illustrate how decisions around accounting policies impact financial accounts, and in this case the profits disclosed.
You may have got to the end of this section and wondered why would this method be used at all – the straight-line method is much simpler. This is true, but the effective interest method, as the name suggests, provides a more “true” disclosure of the interest burden ABC is committed to each year when compared to the straight-line method. It achieves this through reflecting the fact that the longer this debt is held the greater the impact the premium has on ABC’s financing costs; just as a discount has the opposite impact.
Repayment of a Bond
We are almost there, now it’s only the repayment of the bond at maturity that is required. As we recognised back on the issuing of the bond, there is a liability of $1,740,000 that requires repayment. So after the final interest and premium amortisation journals have been posted the repayment journal would be:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Sept 30 | Bonds Payable | 1,740,000 | |
| Bank | 1,740,000 |
The bonds payable account will be reduced to $0 with the debit of $1,740,000. While the credit of the same amount brings to account the payout to bond holders. Remember, although they paid $2,011,251 for the bond issue, $271,251 of this was a premium above par value they were willing to pay. The par value being: 87 bonds x $20,000 par value = $1,740,000.
Conclusion
Although on the face of it the journal entry for a bonds payable premium looks straight forward enough, there is actually quite a lot involved. We covered what a bond is and what it might be used for. We then noted it was an adjunct account and the debits and credits involved. In particular, we worked through what was required to issue a bond, make the regular interest payments, how we would amortise the premium and the final payment at maturity.
Don’t be put off by the work involved in the effective interest method. Once you understand the calculations involved and why the method is used, it becomes much simpler to implement and a lot less daunting the next time you face applying it.