Definition of Amortization of Premium on Bonds Payable
The amortization of the premium on bonds payable is the systematic movement of the amount of premium received when the corporation issued the bonds. The premium was received because the bonds' stated interest rate was greater than the market interest rate.
The amount of the premium is recorded in a separate bond-related liability account. Over the life of the bonds the premium amount will be systematically moved to the income statement as a reduction of Bond Interest Expense.
Example of Amortization of Premium on Bonds Payable
Assume that a corporation issues bonds payable having a maturity value of $1,000,000 and receives a premium of $60,000. The bonds mature in 20 years and there was no accrued interest at the time the bonds are issued.
The corporation will record the bonds as follows:
- Debit Cash for $1,060,000 (the amount received from investors)
- Credit Bonds Payable for $1,000,000 (the face, par, and maturity amount)
- Credit Premium on Bonds Payable for $60,000 (the amount to be amortized)
Since the premium of $60,000 is related to the interest rates when the bonds were issued, the amortization of the premium will involve the account Interest Expense or Bond Interest Expense. Since the bonds mature in 20 years, the $60,000 of premium on bonds payable will mean an annual amortization of $3,000 ($60,000/20 year). The entry for the annual amortization will be the following:
- Debit Premium on Bonds Payable for $3,000
- Credit Interest Expense for $3,000
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 large amount.