Bond premium

Definition

A bond premium occurs when a bond is sold for more than its face value due to the bond's stated interest rate being higher than the prevailing market interest rates. This excess price reflects the additional interest income that investors will receive from holding the bond compared to newer bonds issued at lower rates. It plays a significant role in understanding how bonds are accounted for, including how to prepare journal entries throughout their life cycle and how it relates to broader concepts of long-term liabilities.

5 Must Know Facts For Your Next Test

1. When a bond is issued at a premium, the issuer receives more cash than the face value of the bond, reflecting favorable terms for investors.
2. Premiums are amortized over the life of the bond, which reduces the amount of interest expense reported on financial statements.
3. A bond trading at a premium generally indicates investor confidence in the issuer's creditworthiness and desire for higher returns.
4. The amortization of a bond premium will affect both the book value of the bond on the balance sheet and interest expense on the income statement.
5. At maturity, a bond sold at a premium will be redeemed at its face value, resulting in a loss equal to the amortized premium over its life.

Review Questions

• How does a bond premium affect journal entries during the life cycle of a bond?
  • When a bond is issued at a premium, journal entries must reflect the higher cash inflow and establish a premium liability account. As time progresses, entries for amortizing this premium reduce the interest expense recorded, thus impacting both financial reporting and tax implications. Properly accounting for this ensures that financial statements accurately depict interest expenses and liabilities.
• Discuss how the presence of a bond premium influences an investor's decision-making process.
  • Investors considering bonds with premiums may evaluate their yield to maturity against current market rates. A higher coupon rate might justify paying more upfront if they anticipate holding it until maturity and benefiting from consistent interest income. Understanding how premiums influence overall returns allows investors to make informed decisions about risk and potential rewards when choosing among various bonds.
• Evaluate the implications of bond premiums on long-term liability management for companies.
  • Companies with bonds issued at a premium benefit from receiving more capital upfront than face value. However, this also requires careful management of amortization schedules that impact future financial statements. As these companies navigate their long-term liabilities, they must balance cash flows from interest payments with reduced expenses related to amortization, ensuring they maintain healthy financial health while meeting obligations.

Related terms

face value: The nominal or dollar value of a bond as stated on the bond certificate, which is the amount paid back to the bondholder at maturity.

yield to maturity: The total return anticipated on a bond if it is held until it matures, considering both interest payments and any capital gains or losses.

amortization: The process of gradually writing off the initial cost of an intangible asset or the premium or discount on bonds over time, affecting the reported interest expense.