What it means
When your business borrows money by issuing bonds, the face value is what you promise to pay back at maturity. However, financial markets constantly shift.
If your company has a stellar credit rating or if you offer an interest rate that is higher than what investors can currently get elsewhere, they will gladly pay you more than the face value just to get those high regular interest payments. This extra cash you receive upfront is recorded on your balance sheet as a premium on bonds payable.
It sits right alongside the bond liability as an addition. Because you received more cash than you will eventually have to pay back at the end of the bond term, you do not get to keep that extra money as instant profit.
Instead, accounting rules require you to gradually reduce, or amortise, this premium over the lifetime of the bond. As you amortise the premium each year, it acts as an offset to your interest expense.
This means your reported interest expense on the income statement will actually be lower than the cash interest payments you make to your investors. Understanding this concept helps non-finance managers see why the actual cost of borrowing is lower when investors are willing to pay extra for your debt instruments.
Imagine selling a popular concert ticket for $100 when the face value is $80 because everyone wants to see the show. The extra $20 is your premium.
In practice
Real-world examples
Example 1
TechStart issued a $100,000 bond with an attractive 7% interest rate when market rates were 5%. Eager investors paid $105,000 for it, creating a $5,000 premium. The company records $100,000 as the bond liability and the $5,000 as a premium to be amortised over the life of the bond.
Example 2
GreenLogistics, a mid-sized transport firm, sold $500,000 of bonds at $520,000 because of its strong brand reputation, generating a $20,000 bond premium. The premium is 20,000 / 500,000 = 4% of face value. Over a 10-year term it will reduce interest expense by $2,000 a year.
Example 3
MetroRetail issued $1,000,000 in corporate bonds. Due to high market demand for stable retail debt, investors paid $1,025,000, resulting in a $25,000 premium. The finance team records the cash received of $1,025,000 and recognises the premium gradually, not as an instant gain.
Think of it
Imagine selling a popular concert ticket for 100 pounds when the face value is 80 pounds because everyone wants to see the show. The extra 20 pounds is your premium.
Formula
Calculation
Carrying Value = Face Value of Bond + Unamortised Premium
Annual Premium Amortisation (straight-line) = Total Premium / Years to Maturity
Annual Interest Expense = Cash Interest Paid - Premium Amortisation
Example: Your bond has a face value of $100,000 and was issued with a $4,000 premium, so the carrying value on your balance sheet at issue is 100,000 + 4,000 = $104,000. Each year, a portion of that $4,000 is moved to reduce your interest expense until the premium reaches zero at maturity.
Suppose the bond has a 5-year life and a 7% coupon. The yearly amortisation is 4,000 / 5 = $800, the cash interest is 100,000 x 7% = $7,000, and the interest expense is 7,000 - 800 = $6,200. After 2 years the unamortised premium is 4,000 - 1,600 = $2,400, so the carrying value is 100,000 + 2,400 = $102,400, and after 5 years it is exactly $100,000.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightSpark Energy decided to expand its solar panel operations by issuing $2,000,000 worth of 10-year bonds. Because BrightSpark had a fantastic track record and offered an annual interest rate of 6% while market rates hovered around 4%, investors rushed to buy the debt. As a result, investors paid a total of $2,150,000 for the bonds, providing BrightSpark with an immediate $150,000 premium on bonds payable. The finance team recorded the bond liability at its $2,000,000 face value, the cash received as $2,150,000, and the difference as the $150,000 premium.
Over the 10-year life of the bonds, the accountant amortised this premium at $15,000 per year using the straight-line method. When BrightSpark paid $120,000 in cash interest to investors each year, the $15,000 reduction from the premium meant that the interest expense recorded on the income statement was only $105,000. This accurately reflected the true, lower cost of borrowing money that investors were willing to pay extra to hold. At the end of year 1, the carrying value of the bonds was 2,000,000 + 150,000 - 15,000 = $2,135,000, and it declined by $15,000 each year until it equalled the $2,000,000 face value that BrightSpark repaid at maturity.
Watch out
Common mistakes
- Treating the extra cash received from the premium as immediate revenue or profit.
- Forgetting to amortise the premium over the life of the bond, which distorts the balance sheet.
- Subtracting the premium from the bond face value instead of adding it to determine carrying value.
Questions
People also ask
Why would an investor pay more than the face value of a bond?
Investors pay a premium when the bond's stated interest rate is higher than current market interest rates, or when the issuing company is exceptionally reliable.
Does a bond premium increase or decrease my interest expense?
A bond premium decreases your reported interest expense on the income statement over time because it offsets the cash interest payments made to investors.
What happens to the premium when the bond matures?
The premium is fully amortised by the maturity date, meaning its balance drops to zero, and the carrying value of the bond equals its face value when repaid.