Source: Bonds Examples, Journal Entries, Amortization Schedules & Calculations
Tags: premium bonds, bond premium, premium on bonds payable, effective interest method, straight-line amortisation, bond redemption, carrying value, present value
Difficulty: Intermediate | Prerequisites: Bond pricing fundamentals and discount bonds (see companion notes). Time value of money.
Premium bonds are the mirror image of discount bonds. Everything you learnt about discount bonds still applies here, only the direction reverses. When the coupon rate exceeds the market rate, investors are willing to pay more than face value because the bond's interest payments are more generous than what the market demands. The premium is then amortised downward over the bond's life, reducing interest expense each period until the carrying value returns to face value at maturity.
When a bond's coupon rate exceeds the market rate, the bond sells above face value (at a premium). The premium is amortised downward each period, reducing interest expense below the cash interest paid. Under the effective interest method, interest expense decreases over time as the carrying value declines. Under straight-line, it stays constant. On early redemption, a gain or loss equals the carrying value minus the call price.
Premium on bonds payable
An adjunct liability account (added to Bonds Payable) that arises when a bond is issued above face value (coupon rate > market rate). It represents the amount by which the issue price exceeds the face value. In simple terms, the issuer received more cash than it must repay, and the premium offsets the higher-than-market coupon payments over the bond's life.
Premium amortisation
The process of reducing the premium balance each period. Under the effective interest method, amortisation = cash interest paid minus interest expense. Under straight-line, it is the total premium divided equally across all periods. Each period's amortisation reduces the carrying value toward face value.
Gain on bond redemption
Recorded when the call price is less than the carrying value at the redemption date. This happens most often with premium bonds redeemed at a price below their (above-par) carrying value. The gain is an income statement item, reported net on the income statement.
Worked example (premium bond):
Face value = $700,000. Coupon rate = 12% annually, paid semiannually. Market rate = 10% annually. Maturity = 3 years.
Convert to per-period terms:
Cash interest per period = $700,000 × 6% = $42,000
Market rate per period = 10% / 2 = 5%
Number of periods = 3 × 2 = 6
PV of interest payments = $42,000 × PV annuity factor (5%, 6 periods) = $42,000 × 5.07569 = $213,179
PV of face value = $700,000 × PV factor (5%, 6 periods) = $700,000 × 0.74622 = $522,351
Bond issue price = $213,179 + $522,351 = $735,530
The bond sells for $735,530 against a face value of $700,000, creating a premium of $35,530. The coupon rate (12%) exceeds the market rate (10%), so investors are willing to pay above face value.
At issuance, debit Cash for the full proceeds, credit Premium on Bonds Payable for the excess, and credit Bonds Payable for the face amount:
Dr. Cash: $735,530
Cr. Bonds Payable: $700,000
Cr. Premium on Bonds Payable: $35,530
The premium is an adjunct liability. On the balance sheet, Bonds Payable of $700,000 plus Premium of $35,530 gives a net carrying value of $735,530.
Under the effective interest method, interest expense each period = beginning carrying value × market rate per period (5%). The difference between the $42,000 cash payment and the (lower) interest expense is the premium amortisation, which decreases the carrying value.
Period | Carrying Value (start) | Interest Expense (CV × 5%) | Cash Paid | Premium Amortised | Carrying Value (end) |
|---|---|---|---|---|---|
1 | $735,530 | $36,777 | $42,000 | $5,224 | $730,307 |
2 | $730,307 | $36,515 | $42,000 | $5,485 | $724,822 |
3 | $724,822 | $36,241 | $42,000 | $5,759 | $719,063 |
4 | $719,063 | $35,953 | $42,000 | $6,047 | $713,016 |
5 | $713,016 | $35,651 | $42,000 | $6,349 | $706,667 |
6 | $706,667 | $35,333* | $42,000 | $6,667 | $700,000 |
*Period 6 is adjusted so the carrying value reaches exactly $700,000 at maturity.
Notice the pattern: interest expense decreases each period for a premium bond. As the carrying value falls, a smaller base is multiplied by the same 5% rate. Premium amortisation increases each period (the opposite of what happens with discount amortisation).
Total interest expense = $216,470, which equals total cash interest paid ($252,000) minus the total premium amortised ($35,530).
Premium amortised per period = $35,530 / 6 = $5,922 (with rounding adjustment in the final period)
Interest expense per period = cash interest minus premium amortisation = $42,000 - $5,922 = $36,078
Period | Carrying Value (start) | Interest Expense | Cash Paid | Premium Amortised | Carrying Value (end) |
|---|---|---|---|---|---|
1 | $735,530 | $36,078 | $42,000 | $5,922 | $729,608 |
2 | $729,608 | $36,078 | $42,000 | $5,922 | $723,686 |
3 | $723,686 | $36,078 | $42,000 | $5,922 | $717,764 |
4 | $717,764 | $36,078 | $42,000 | $5,922 | $711,842 |
5 | $711,842 | $36,078 | $42,000 | $5,922 | $705,920 |
6 | $705,920 | $36,080* | $42,000 | $5,920 | $700,000 |
*Adjusted for rounding.
Effective interest method, June 30, 2019 (Period 1):
Dr. Interest Expense: $36,777
Dr. Premium on Bonds Payable: $5,224
Cr. Cash: $42,000
Notice the key difference from discount bonds: the premium is debited (reduced), not credited. The cash payment exceeds the interest expense, and the excess reduces the premium.
Effective interest method, December 31, 2019 (Period 2):
Dr. Interest Expense: $36,515
Dr. Premium on Bonds Payable: $5,485
Cr. Cash: $42,000
Straight-line method, June 30, 2019 (Period 1):
Dr. Interest Expense: $36,078
Dr. Premium on Bonds Payable: $5,922
Cr. Cash: $42,000
Straight-line method, December 31, 2019 (Period 2):
Identical to Period 1 under straight-line.
Masterwear calls the bonds on January 1, 2020, at a call price of $720,000.
Under the effective interest method:
Carrying value after Period 2 = $724,822.
Remaining premium = $724,822 - $700,000 = $24,822.
The carrying value ($724,822) exceeds the call price ($720,000), so the issuer records a gain of $4,822. The issuer is settling a $724,822 liability for only $720,000.
Dr. Bonds Payable: $700,000
Dr. Premium on Bonds Payable: $24,822
Cr. Cash: $720,000
Cr. Gain on Bond Redemption: $4,822
Under the straight-line method:
Carrying value after Period 2 = $723,686.
Remaining premium = $723,686 - $700,000 = $23,686.
Gain = $723,686 - $720,000 = $3,686.
Dr. Bonds Payable: $700,000
Dr. Premium on Bonds Payable: $23,686
Cr. Cash: $720,000
Cr. Gain on Bond Redemption: $3,686
Students often get the journal entry backwards for premium amortisation. With a premium bond, the premium account is debited (reduced) each period, and interest expense is less than the cash paid. This is the opposite of discount bonds, where the discount is credited (reduced) and interest expense exceeds the cash paid.
It is a common mistake to think a premium means the issuer "made money." The premium simply reflects the fact that the coupon payments are above-market. The issuer pays higher-than-market cash interest each period, and the premium amortisation offsets that.
When recording a gain on early redemption, students sometimes credit Cash instead of debiting Bonds Payable and the premium. Remember: you are removing the entire liability from the books (face value plus remaining premium), paying the call price in cash, and plugging the difference as a gain.
Students sometimes confuse the direction of interest expense movement. For premium bonds under effective interest, expense decreases each period (falling carrying value × constant rate). For discount bonds, it increases. A quick check: if the carrying value is falling, so is the expense.
⚠️ Exams frequently place a discount bond and a premium bond side by side and ask you to contrast the journal entries. Be ready to write both.
⚠️ A common exam format: given a partial amortisation schedule with one or two blanks, fill in the missing figures. Practise computing any single cell from the others.
⚠️ The redemption journal entry for premium bonds is tested as often as discount bonds. Remember that a gain is more common with premium bonds (carrying value above face, call price near or at face), while a loss is more common with discount bonds.
Companies sometimes issue bonds at a premium intentionally by setting a coupon rate above the prevailing market rate. This can signal financial strength or attract certain investors who want higher periodic cash flows. The premium received up front is not "free money": it is offset by the higher-than-market interest payments over the bond's life.
True or false: A bond sells at a premium when the market rate exceeds the coupon rate.
False. A premium occurs when the coupon rate exceeds the market rate.
Fill in the blank: Under the effective interest method for a premium bond, interest expense each period equals ______ multiplied by the ______.
Beginning carrying value; market rate per period.
True or false: Premium on Bonds Payable is a contra-liability account.
False. It is an adjunct (addition to) liability account. Discount on Bonds Payable is the contra-liability.
Fill in the blank: When a premium bond is redeemed early and the carrying value exceeds the call price, the issuer records a ______.
Gain on bond redemption.
True or false: Under the effective interest method for a premium bond, interest expense increases each period.
False. Interest expense decreases each period because the carrying value (the base) is declining.
Q: A $700,000, 12% bond (semiannual interest) is issued when the market rate is 10%. Is the interest expense in Period 3 higher or lower than in Period 1 under the effective interest method?
A: Lower. The carrying value decreases each period as the premium is amortised, so the base for computing interest expense shrinks. Period 3 has a lower carrying value than Period 1, producing lower interest expense.
Q: After two periods of effective interest amortisation, a premium bond has a carrying value of $724,822. The bonds are called at $720,000. What is recorded?
A: A gain of $4,822. The carrying value ($724,822) exceeds the call price ($720,000). The entry debits Bonds Payable for $700,000 and Premium on Bonds Payable for $24,822, credits Cash for $720,000 and Gain on Bond Redemption for $4,822.
Q: How does the journal entry for interest on a premium bond differ from a discount bond?
A: For a premium bond, the premium account is debited each period (reducing it), and interest expense is less than the cash payment. For a discount bond, the discount account is credited each period (reducing it), and interest expense exceeds the cash payment. In both cases, Cash is credited for $42,000.
Q: What is the total interest expense over the life of this $735,530 premium bond?
A: Total cash interest paid ($42,000 × 6 = $252,000) minus total premium amortised ($35,530) = $216,470. The premium effectively reduces the issuer's total interest cost because the issuer received more than face value at issuance.
Premium bonds are the direct counterpart to discount bonds. Mastering both cases means understanding the full spectrum of bond accounting. The same present-value mechanics apply to installment notes and lease liabilities, which also involve discounting future payments at a market rate.
Early extinguishment of bonds (whether at a premium or discount) connects to the broader topic of how gains and losses on debt retirement are reported in the income statement.
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