Let's use the following example to illustrate the amortization of premium on bonds payable: A corporation issues bonds having a face value of $1,000,000 and receives a premium of $60,000. The bond premium occurred because the bonds' stated interest rate was slightly greater than the interest rate required by the investors in the bond market.
The corporation records the bonds as follows: debit Cash for $1,060,000; credit Bonds Payable for $1,000,000; credit Premium on Bonds Payable for $60,000. The Premium on Bonds Payable is a liability account that must be reduced to $0 by the time the bonds mature. Reducing the Premium on Bonds Payable each period by a logical amount is called amortizing the premium on bonds payable or amortizing the bond premium.
Since the premium of $60,000 is related to the interest rates when the bonds were issued, the amortization of the premium involves the account Interest Expense. If we assume that the bonds will mature 20 years after they were issued, then each year the corporation will make this entry: debit Premium on Bonds Payable $3,000 and credit Interest Expense $3,000. As you can see, the $60,000 difference between the $1,060,000 it received and the $1,000,000 it must repay is reported as a reduction of interest expense over the life of the bonds.
Reducing the balance in the account Premium on Bonds Payable by the same amount each period is known as the straight line method of amortization. A more precise method, the effective interest rate method of amortization, is preferred when the amount of the premium is a very large amount.