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Sale or Issuance of Bonds at a Premium in Financial Accounting

Suppose the market rate of interest on January 1, 2000, when the Marley Company bonds were sold, is below the coupon rate of 12%. In this case, investors would find the bonds to be quite attractive because the coupon rate is higher than the market interest rate available on other investments of equivalent risk. As a result, the market price of Marley’s bonds increases. The bonds are issued at a premium, in other words, at an amount greater than the principal amount of $100 million. For example, if the market interest rate is 8% when the bonds are issued, investors will be willing to pay $127,140,000, a price of 127.14, determined as follows.

Principal, due in 20 six-month periods at 4% (half the 8% annual rate):

Interest payments, due each six months for 20 periods:

Consequently, the bonds will sell at $127,140,000 ($100,000,000 face value + $27,140,000 premium). The total interest expense over the life of the bonds is determined as follows:

The amount of interest expense to be recognized each interest period (each six months in this example) is based on the reported value of the bonds at the start of the interest period. figure 8.2 shows how the interest expense during 2000, 2001, and 2009 would be determined.

Figure 8.2 - Calculation of Interest Expense

NOTE: The reported value of the bonds decreases each period because the amount paid to the bondholders exceeds the interest expense, which decreases the company’s obligation to the bondholders. On the maturity date of the bonds, the reported value will equal the principal (face) amount of $100 million.

The amount of this interest expense to be recognized in each period would be determined as before; the reported value of the bonds at the start of each interest period would be multiplied by the market rate of interest when the bonds were issued. The logic of this calculation is the same as that shown in figure 8.1 in "Sale or Issuance of Bonds at a Discount" for the case of bonds sold at a discount. The total interest expense incurred by Marley Company over the life of bonds sold at a premium will be less than the total interest coupons paid. In effect, the premium represents a reduction in interest paid to the bondholders, to compensate for the fact that the coupon rate is too high.

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