11. Long Term Liabilities
Premium on Bonds
Issuing Bonds at a Premium
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All right? So let's move on to the premium on bonds payable. Now I want you guys to go ahead and after this lesson, compare the discount and the premium and see how much they have in common and are basically opposites of each other. So what do you guys remember about the stated rate and the market rate when we're talking about premiums? So when the stated rate, let's say is 12%. Now we're saying with our bonds, hey check out our bonds, we're offering 12% and the market all the similar bonds to our bonds are only offering 10%. People are gonna prefer ours. Right? Ours are more enticing because we're paying higher interest rate. So this is when a premium exists is when the stated rate is greater than the market rate. Okay, let's go ahead and do our our summary table right quick. And remember we've dealt with these other ones already. We dealt with a situation where the stated rate and the market rate are equal and this was a face value bond sometimes called a par value bond and the price of the bond will be equal To the face value in that case. Now, what about the situation we just discussed where the stated rate was less than the market rate, the stated rate is 8% while the market rate is 10%. Well, the price of the bond is going to be less, right? Our our bond in that case is less enticing than the market Because we're offering less interest. So investors will pay less for it and they will pay at a discount. Now in this video we're gonna be focused on the premium. That's a situation where we're offering more, just like we said, we're offering 12% when the market offers 10%. Well, the price of the bond is going to be greater than the par value. Right? And that's because our interest rate is higher, they're going to be sold at a premium. Okay. So let's go ahead and see how the issuance entry when we first issue the bonds, what that's going to look like when we are dealing with a premium situation. Okay. So we have very similar details to our previous examples. On january 1st 2018 abc company issues $50,000 of 9% bonds payable, maturing in five years. So remember this, $50,000. This is the principal amount, The face value of the bonds. Okay. And that's the amount that will calculate our cash interest, the amount of cash interest we pay. That's gonna be dealt with this stated interest rate. The bonds say they're gonna pay 9% interest um And they mature in five years. Right? So it's five years. Five year bonds and interest is payable semiannually, which means two payments per year, right? Every six months we are going to make interest payments. So you might see annual bonds or semi annual bonds. Either way, semiannual tend to be more common because it's a little more complicated. We gotta make two payments per year. Okay january 1st and july 1st is those interest payment dates. Now notice the market interest rate in this case is 8% right? We're offering 9%. The market is only offering 8%. Well our bonds are more enticing they're going to be sold at a premium and that's exactly what we see. Right here, the bonds were issued at 108,000. Excuse me? At 100 and 880% of their face value. So the 108 means 100 and 8% of the face value. Now, that could have been any number, but they had to give it to you right in this case they sold for 108 uh percent of the face value. So let's go ahead and see how much cash we received. Right? That's what it tells us. That one oh eight tells us how much cash we received. And that's gonna be the 50,000 times 1.08 right? Because it's 108%, which is 1.08. So let's go ahead and see what that comes out to 50,000 times 1.08. Well that comes out to 54,000 and that's the amount of cash we're gonna receive from selling these bonds. So that's gonna be our debit to cash, we're gonna receive 54,000 in cash. Okay so that is our debit um in this entry and we're gonna have a credit, we owe money now right we took on this liability for bonds payable. Well what is going to be Our credit to bonds payable in this case? Is it gonna be 54,000? No just like we said right the bonds payable is always going to be in the amount of the face value. The face value of those bonds are 50,000 and this always has to be Always face value going into the bonds payable account. Okay 50,000 is the bonds payable but this doesn't balance right? We've got debits of 54,000 and credits of 50,000 in this case. So we need 4000 more credits. So we're gonna need 4000 more in credits over here. And guess what? That's gonna be. That's gonna be our premium on bonds payable premium on the bonds payable. I'm gonna put premiums on BP. That's usually how we abbreviate this premiums on bond payable. Okay so that 4000 extra is going to be sitting in another account. We keep the principal account in the bonds payable account and then we have this related account not necessarily a contra account because it's increasing the value right? It has a credit balance, we have the credit balance of 50,000 plus another credit balance of 4000. So it's increasing the value of bonds payable based on this extra cash we received. Okay so when we see our balance sheet our balance sheets gonna show this cash we receive the 54,000. It's going to be increasing our cash balance. But on our liabilities now we're gonna be showing our bonds payable account. So when we show our balance sheet we're gonna have our bonds payable account sitting on 50,000 as a credit right? It's gonna show a liability of 50,000. But it's also gonna say plus premium, Right? Because the carrying value of the bond is not just the 50,000, it also has this premium associated with it of 4000. So when we show our balance sheet it's gonna show a bonds payable of 54,000. Or excuse me, not just the bonds payable, the bonds payable plus the premium is gonna show a balance of 54,000. Okay. And that's equal to the cash we received. So our our equation stays balanced here. Okay. So it's a big note when we make our journal entry that the bonds payable account always just has the face value of the bonds and then we store the difference from the cash we received and the bonds payable in either the discount or the premium. Okay? So let's go ahead and move on to our interest expense. Journal entry
Premium Bonds:Interest Expense, Amortization, and Cash
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Alright, let's continue here with our interest expense, journal entries starting with the one on july 1st 2018. Okay, so remember this bond pays interest semiannually, right? So that means we're paying interest twice per year basically every six months. Right? So our first uh interest payment is going to happen on july 1st. We issued them on january 1st. Well we're not gonna pay any interest on the day we issued them. No time has passed. So the first interest payment happens july 1st. And remember up above, we had our uh our premium, that was 4000, right? We had a $4000 premium that was increasing the value of the bonds. Well, what we're gonna do here is we're gonna use the straight line method of amortization. There's another method that's more complicated called the effective interest method. Now the effective interest method is gap but we're gonna use the straight line method because it's easier. And generally in your class you just use the straight line method if your teacher wants to be a little more complicated or your textbook goes into more details, we are going to go into the details of the effective interest method. Don't worry, we're gonna keep it simple for you. But for now let's stick with the straight line method so we can learn these concepts. Okay, so when we use the straight line method, what we do is what we take the total premium or total discount amount, which in this case was 4000 premium. Right? Our premium was 4000 and we divided by the total number of interest payments, Right? Just like we did with the straight line method for depreciation, right? We had the number of years that were depreciating over. Well here it's the same thing. We're advertising over 10 periods, right? We have a five year bond and we're paying interest twice per year. So five years times the two times per year. Well, there's gonna be 10 total interest payments. Alright, we're gonna pay interest 10 times. So each of those times we're gonna advertise some of this premium 4000 divided by 10. It comes out to 400 per uh interest payment that we are going to advertise. Okay. And I keep saying this Amber ties, What does it mean? Well, hopefully you're comfortable with it from our discount discussion, but let's go ahead and see how it's a little different for premiums compared to discounts. Alright, So we're gonna have our 400 amortization of our of our premium. But what About the cash interest? Right. We are going to pay some interest in cash that we owe to to the investors. So the cash interest. Well, that's going to be calculated as the 50,000 in principle, times the 9%.. But that's an annual interest rate, right? 9% per year. Well, we're only paying for half a year right now, right? It's only been six months january through uh through june? And now it's july 1st. So we divide by 2 50,000 times point oh nine divided by two let's go ahead and do that. It comes out to 2250. And that's the amount of cash interest we're gonna pay. But then we're also gonna advertise this premium. So let's go ahead and see what that means. We're gonna have a credit to cash here right we're gonna have a credit to cash in the amount of 2250 because that's the amount of cash that's actually coming out of our pocket. However this premium we're gonna start getting rid of it over the life of the The life of the loan of the bonds payable. So like we calculated it's gonna be 400 per interest payment. Now remember when we first created our premium in the previous entry? It had a credit balance right? It had a credit balance because it was increasing the value of our liability. Well guess what? To get rid of the premium. We're gonna have to use debits to get rid of that premium because it has a credit balance when we get rid of it with debits. So we're gonna have a debit here to premium on bonds payable and that's going to be in the amount of 400. Right? We're gonna get rid of 400 per payment period for the next five years. Right? So over the 10 payment periods we're gonna get rid of 400 each time. And then after the 10 payment periods are over. Well it's gonna be completely gone. Right? So let's look at that in a T. Account real real quick. We have the premium on the bonds payable and it had a $4000 credit balance to start with. Right? Well in this journal entry we just took away 400 with a debit. So it's left with a 36 100 credit balance. So what does this do to our balance sheet? Well remember when we show our balance sheet, we're gonna show our bonds payable And that bonds payable is going to be sitting at 50,000. Right? It shows the the principal amount, the face value of the bonds and the bonds payable account. And then we're gonna add the premium or subtract the discount. In this case we're talking about premiums So we add the premium and that's going to be in the amount of 3000 In this case. 3600. Right? So we're gonna show a carrying value of the bonds of 53,600. Notice that originally in our first entry They had a carrying value of 54,000 right here. Right? The 5000 plus, excuse me the 50,000 plus the 4000 in the premium. Well now the premium is a little less. Right? Because we're advertising some of it into the interest expense. Well the premium is gonna keep decreasing over the life of the bond. Okay? So right now we've gotten rid of 400 of it. So there's 3600 left, and it's gonna show on our balance sheet. This value of 53,600 uh for our caring value of bonds payable. Okay. So our journal entry isn't complete yet. Right? We've got a credit for 2250. We've got a debit for 400. Well, we're gonna need one more debit here and that debit needs to balance us out. And that's gonna be the difference there. The 1000 850. So we need to figure that out, just like that. We know we figured out our premium amortization, we figured out our cash. Well, we're going to subtract the two to get our interest expense right? Remember this is an interest journal entry. So there's going to be interest expense. And that's gonna be the difference here. We Notice that in this case the interest expense is lower because we already had a debit for the premium on the bonds payable. Well, we balance it with the 1850 and it's less than the cash payment, right? And this makes sense? Because we what we're essentially doing is we're equating our interest expense. What we're showing on our income statement to that market rate. Notice that the market rate is a little lower than what are our bond is paying now? It's not going to be exact here, but it gets us closer to what the market is paying. Alright. Something closer to that amount. Alright. So that's what we're exactly what we're showing here is we're gonna be advertising the premium, we're gonna be paying the cash amount of interest that stated on the bond and then the difference is going to be the interest expense. Okay. So we saw a cash decrease by 2250 and we saw our liabilities. What happened to our liabilities in this case? What happened in this premium account that are liabilities increase or decrease because of this amortization? Our liabilities decreased. Right? Noticed our liabilities before this entry were 54,000. We had the 5 50,000 plus 2 4000. And now they've decreased to 50,000 plus 3600. Because some of this amortization. So the premium the 400 Was a decrease to our liabilities are liabilities are decreasing down to that actual 50,000 that we're eventually going to repay. Okay. And finally we have the interest expense and that's part of equity. Right expenses go to the income statement And that's going to reduce our equity by 1850 and there we go. We're balanced here. We've got our decrease of cash equals our decrease of liabilities and decrease of equity. Cool. Alright. Let's go ahead and move on to the next journal entry
Premium Bonds:Interest Expense, Amortization, and Interest Payable
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All right? So as time keeps passing we're gonna be making more entries for interest expense every six months. So now we reach the end of the year. And we're gonna have to uh crew for those six months that have passed notice that we don't pay interest till January one. But it's December 31. Right? This is December 31 when we're gonna say hey check out our financial statements on December 31. Well we haven't paid this interest yet so we're not going to decrease our cash. We're gonna have interest payable like we saw in our previous entries but all of our numbers are gonna stay the same. Our premium amortization just like we calculated before. I'm gonna put a morte that's gonna be the 4000 that was in the premium divided by the 10 periods. Right? It came out to 400 per period. And then we also had our cash interest which in this case it's not cash right? Because we're not paying it until January one the next day. This is gonna be our interest payable Because we haven't paid it yet. So we have this liability that's going to be that 50,000 times the .09 the 9% interest that the bonds pay divided by two just like we did before. And that comes out to 2250. And notice how similar this journal entry is going to be to the one we just made. So we're gonna have interest payable as a credit. Right? This is a liability until we pay it off tomorrow For 2250. We're gonna have to credit our, excuse me, that's our only credit in this case, we're going to debit our premium just like we did in the previous entry to lower the value of the premium over the life of the bond by the 400 per period. And we're gonna have interest expenses. The difference between the two And that's going to be 1850. Notice all the numbers are the same. The only difference is the interest payable because we're not paying it till next period, right? So you can imagine On on the first of 2019, the very next day we would debit our interest payable to get rid of it and that would be in the 2250 we would pay it in cash 2250. Now I wanna show you real quick, I want to make a note that our premium on the bonds payable is gonna keep decreasing. Right. It started, let me do it in a different color. So it stands out. It started With a $4,000 credit balance when we first issued the bonds and then each time that we pay interest, we're lowering it by 400. Now we've paid interest twice. Well we've lowered it by 400 twice. So the premium is sitting at a $30, balance. And that's gonna keep lowering the balance of our liability that started at 54 1000. And we're gonna keep lowering it over the life of the bond until only the principal value is left. Okay? So let's go ahead and see what happened here. First we have our our interest expense right? Our interest expense is part of equity And that's gonna lower our equity because it's an expense. 1850. And what about the premium on the bonds payable? The premium on bonds payable? Well this is lowering our liabilities just like we saw in the previous entry, right, $400 Less of liabilities, just like we saw our our premium had this credit balance of 4000. Then we lowered it by 400 in the previous entry. Now another 400 in this entry. So it's keep bringing down the value of our liabilities. Finally we have the interest pay. Excuse me. Yes, interest payable. Which is also a liability. And that increases our liabilities by 2250 until we paid off the next day. Right when we paid off the next day. Well that would have, excuse me. That increased increased our liabilities by 2250 because we owe 2250 in the future. Now, well the very next day when we pay it off we'd get rid of that and we would pay it off in cash and that would get rid of that. Right? So that that evens out. and you'll notice that uh our equation stays balanced here, right? So let's go ahead and move on to our final journal entry on the principal repayment date.
Premium Bonds:Repaying Principal at Maturity
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Alright, so let's finish up here with the repayment of principal on the maturity date. So now time has passed. We've made interest payments over the five years and we've been making interest interest expense journal entries like we saw in the previous two journal entries. Okay. So what you think about is if we look at our premium account, if we look at the premium tier account, It started with a balance of 4000 right as a credit balance. And in each of our interest expense journal entries, we were taking away 400 each time. And we've done this 10 times now right times 10 times we did it in total. So that gets rid of the entire balance and there's no premium left. So what's left in the liability is the bonds payable account, right? The bonds payable that had the 50,000 in the principal amount. Well it's finally time to pay off that principal and we're gonna make a journal entry to pay off that principle. So now if we were to look on our, on our balance sheet and look at our liabilities we would have on our liabilities, bonds payable. There we go, bonds payable of 50,000 plus a premium Of zero. Right? At this point we've made all of our journal entries for interest expense. We've paid all our interest expense and there's no no premium left. We've advertised the entire amount into interest expense. So all that's left is the 50,000 in the bonds payable account. What we're gonna finally pay that off. We're going to debit bonds payable for 50,000 and we're going to credit cash for 50,000 cause we're paying them in cash. So we credit the cash to get rid of it and that's it. The final entry is usually very simple. All we gotta do is get rid of the bonds payable and credit the cash. Cool. Alright so that's all that happened here. The cash is going down by 50,000 because we paid out 50,000 in cash and our bonds payable. Bp we no longer owe this liability. We've paid it off So we get rid of the liability. It also decreases by 50,000. Very simple. The toughest thing about this is advertising the premium and advertising the discount especially where I see students struggle is whether we're going to credit the premium when we're discounting it or debit the premium when we're discounting it or excuse me advertising it. Right. What are we gonna do? All you got to think about is that original balance right? When you think about a premium it's increasing the balance of our liability. So it's gonna have a credit balance because it increases a liability with a credit. So how do we get rid of it with debits? So it's gonna be debits to the premium to get rid of it over the course of the interest expense. And the opposite happens with the discount. So before you guys finish up this lesson I want you guys to compare what you did in the previous few pages with discount discount on bonds payable and compared to what we just did with premium on the bonds payable and you'll see that it's very similar, Right? Alright. Let's go ahead and wrap up with a practice problem and then move on to the next topic.
The carrying value (i.e. book value) of Bonds Payable is equal to:
Bonds Payable + Accrued Interest
Bonds Payable – Premium on Bonds Payable
Bonds Payable – Amortization of Premium on Bonds Payable
Bonds Payable – Discount on Bonds Payable