What it means
Imagine a company issues bonds with a face value of $1,000,000 and a coupon rate above the rate investors currently want. Buyers are willing to pay $1,040,000 because the extra interest is attractive.
The $40,000 above face value is the premium, and the company will only ever have to repay $1,000,000. Because the premium does not have to be repaid, it is effectively a reduction in the cost of borrowing.
Accounting therefore spreads it across the bond's life, lowering interest expense a little each period. Each time a slice is used, the unamortised premium falls, until it reaches zero at maturity.
On the issuer's balance sheet, the unamortised premium is added to the face value, so the liability's carrying value starts above the amount to be repaid and falls towards face value. This is the mirror image of a discount.
The carrying value is therefore always face value plus whatever premium remains. The same idea applies to bond investors.
A buyer who pays more than face value amortises the premium against the interest income it receives, so reported income is lower than the cash coupon. This avoids overstating profit on a bond that will return less principal than was paid.
Methods follow the same pattern as for discounts, with the straight-line method being simple and the effective interest method generally preferred. A manager reading the accounts should remember that the premium reduces reported interest cost even though the cash coupons stay the same.
The unamortised premium also helps explain why a bond can look expensive to carry in cash terms but cheaper in reported terms. Comparing both views gives a fuller picture of what the borrowing really costs.
In practice
Real-world examples.
Example
A utility issues $3,000,000 of bonds paying a 7% coupon when the market rate is 6%. Investors pay $3,150,000, and the $150,000 premium is released at $15,000 a year over 10 years, lowering reported interest expense each year. The cash coupons paid stay the same throughout.
Example
An investment fund buys a bond at 103% of face value, paying $515,000 for a $500,000 holding. It amortises the $15,000 premium over the remaining life, so income recorded each year is lower than the cash coupon it collects. This stops income being overstated on a bond that will return less principal than the fund paid.
Example
A hospital group's year-end working papers show a bond with 5 years left and a remaining premium of $20,000. The auditor checks that the balance sheet shows face value plus $20,000 and that next year's interest expense is reduced by the scheduled slice.
Formula
Calculation
Unamortised premium = Issue price - Face value - Premium amortised to date
Carrying value = Face value + Unamortised premium
A company issues $1,000,000 of bonds for $1,040,000, so the premium is $40,000, spread evenly over 10 years using the straight-line method. Each year, 40,000 / 10 = $4,000 reduces interest expense. After 3 years, amortised premium is 3 x 4,000 = $12,000, so the unamortised premium is 40,000 - 12,000 = $28,000. The carrying value is 1,000,000 + 28,000 = $1,028,000.Case study
Seen in the real world.
Silverline Telecom is an illustrative, fictional company that issued $10,000,000 of ten-year bonds with a generous coupon during a period when market rates fell. Investors paid $10,400,000 and the extra $400,000 was recorded as a premium.
The junior accountant booked the whole premium as other income in the year of issue, which made profit look unusually strong. The reviewing controller reversed the entry and set up an amortisation schedule that released $40,000 a year against interest expense.
The illustrative outcome was a smoother and more accurate profit profile, and the cash coupons and reported interest cost were finally explained in the notes. The company now checks every bond issued above par for a premium schedule. The controller also added a line to the month-end checklist asking whether any new debt was issued at a price different from face value, so that the schedule is prepared before the first interest payment.
Watch out
Common mistakes.
- Treating the premium as immediate income, which overstates profit in the year of issue and understates it later.
- Believing the premium must be repaid, when only the face value is repaid at maturity.
- Using the straight-line method where the effective interest method is required, which can misstate each year's interest expense.
Questions
People also ask.
Why do bonds sell at a premium?
Because the coupon rate is higher than the yield investors currently require, so buyers pay more than face value for the extra interest.
Where does the premium appear on the balance sheet?
It is added to the bond's face value in the liability section, and the combined figure is the carrying value.
Does an investor amortise a premium too?
Yes, an investor who pays above face value spreads the premium over the holding period, which lowers the interest income it reports.
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