When analyzing bonds, understanding the concepts of discounts and premiums is crucial, particularly in relation to interest rates. The relationship between the stated interest rate of a bond and the market interest rate determines whether a bond is sold at face value, a discount, or a premium. When the stated rate equals the market rate, the bond sells at its face value, also known as par value. However, if the stated rate is less than the market rate, the bond will sell at a discount, meaning its price is below face value. Conversely, if the stated rate exceeds the market rate, the bond sells at a premium, with its price above face value.
For example, consider a bond issued by ABC Company on January 1, 2018, with a face value of $50,000 and a stated interest rate of 9%, while the market interest rate is 8%. Since the stated rate is higher than the market rate, this bond is issued at a premium, specifically at 108% of its face value. To calculate the cash received from the bond issuance, multiply the face value by the issue price: $50,000 × 1.08 = $54,000. This results in a premium of $4,000, as the bond will only require repayment of the face value of $50,000 at maturity.
The journal entry for this transaction reflects a debit to cash for $54,000, a credit to bonds payable for $50,000, and a credit to premium on bonds payable for $4,000. This entry indicates an increase in liabilities, with bonds payable recorded at the principal amount and the premium recognized as an additional liability. The total cash inflow from the bond issuance is thus $54,000, which includes the premium.
Moving forward, the amortization of the premium over the life of the bond is essential for accurately reflecting interest expense. The straight-line method of amortization divides the total premium by the number of interest periods, allowing for a consistent reduction of the premium on the financial statements. This method simplifies the accounting process and ensures that the interest expense recognized each period reflects the true cost of borrowing.