Bond Premium with Straight-Line

Amortization
When a corporation prepares to issue/sell a bond to investors, the corporation might anticipate that the
appropriate interest rate will be 9%. If the investors are willing to accept the 9% interest rate, the bond will sell
for its face value. If however, the market interest rate is less than 9% when the bond is issued, the corporation
will receive more than the face amount of the bond. The amount received for the bond (excluding accrued
interest) that is in excess of the bond's face amount is known as the premium on bonds payable, bond
premium, or premium.
To illustrate the premium on bonds payable, let's assume that in early December 2018, a corporation has
prepared a $100,000 bond with a stated interest rate of 9% per annum (9% per year). The bond is dated as of
January 1, 2019 and has a maturity date of December 31, 2023. The bond's interest payment dates are June 30
and December 31 of each year. This means that the corporation will be required to make semiannual interest
payments of $4,500 ($100,000 x 9% x 6/12).

Let's assume that just prior to selling the bond on January 1, the market interest rate for this bond drops to 8%.
Rather than changing the bond's stated interest rate to 8%, the corporation proceeds to issue the 9% bond on
January 1, 2019. Since this 9% bond will be sold when the market interest rate is 8%, the corporation will
receive more than the bond's face value.

Let's assume that this 9% bond being issued in an 8% market will sell for $104,100 plus $0 accrued interest.
The corporation's journal entry to record the issuance of the bond on January 1, 2019 will be:

The account Premium on Bonds Payable is a liability account that will always appear on the balance sheet with
the account Bonds Payable. In other words, if the bonds are a long-term liability, both Bonds Payable and
Premium on Bonds Payable will be reported on the balance sheet as long-term liabilities. The combination of
these two accounts is known as the book value or carrying value of the bonds. On January 1, 2019 the book
value of this bond is $104,100 ($100,000 credit balance in Bonds Payable + $4,100 credit balance in Premium
on Bonds Payable).

Premium on Bonds Payable with Straight-Line Amortization

Over the life of the bond, the balance in the account Premium on Bonds Payable must be reduced to $0. In our
example, the bond premium of $4,100 must be reduced to $0 during the bond's 5-year life. By reducing the
bond premium to $0, the bond's book value will be decreasing from $104,100 on January 1, 2019 to $100,000
when the bonds mature on December 31, 2023. Reducing the bond premium in a logical and systematic
manner is referred to as amortization.
The bond premium of $4,100 was received by the corporation because its interest payments to the bondholders
will be greater than the amount demanded by the market interest rates. Therefore, the amortization of the bond
premium will involve the account Interest Expense. Each accounting period during the life of the bond there
needs to be a credit to Interest Expense and a debit to Premium on Bonds Payable. In this section we will
illustrate the straight-line method of amortization. (In Part 10 we will illustrate the effective interest rate
method.)

Straight-Line Amortization of Bond Premium on Annual Financial Statements

If a corporation issues only annual financial statements and its accounting year ends on December 31, the
amortization of the bond premium can be recorded once each year. In the case of the 9% $100,000 bond issued
for $104,100 and maturing in 5 years, the annual straight-line amortization of the bond premium will be $820
($4,100 divided by 5 years).

However, when a corporation issues only annual financial statements, the amortization of the bond premium is
often recorded at the time of its semiannual interest payments. Under this assumption the journal entries on
June 30 and December 31 will be:

The combination of the interest payments and the bond amortization results in the net amount of $8,180
($4,500 of interest paid on June 30 + $4,500 of interest paid on December 31 minus $410 of amortization on
June 30 and minus $410 of amortization on December 31). This $8,180 will be reported in the account Interest
Expense for the year 2019 as shown in the following T-account:

The following T-account shows how the balance in the account Premium on Bonds Payable will decrease over
the 5-year life of the bonds under the straight-line method of amortization.
The following table shows how the bond's book value will decrease from $104,100 to the bond's maturity
amount of $100,000:

Straight-Line Amortization of Bond Premium on Monthly Financial Statements

If monthly financial statements are issued, the straight-line amortization of the bond premium will be $68.33
per month ($4,100 of bond premium divided by the bond's life of 60 months). Below are the 12 monthly
entries for the amortization plus the June 30 and December 31 payments of semiannual interest during the year
2019:
The journal entries for the years 2020 through 2023 will be similar if all of the bonds remain outstanding.