When a bond is issued at a premium, its market value is more than its face value. To make the concept come alive for you, consider a common example you will see in your intermediate accounting textbook.
Imagine that, for $100,000, an investor is willing to accept an effective interest rate of 6 percent. Using the present value tables, the present value of a $100,000 bond is $79,209 ($100,000 x .79209). The present value of the interest payable is $24,256 ($7,000 x 3.46511). The following figure shows how to calculate the premium on this issuance.
The journal entry to record this transaction is to debit cash for $103,465. You have two accounts to credit: bonds payable for the face amount of $100,000 and premium on bonds payable for $3,465, which is the difference between face and cash received at issuance.
The premium of $3,465 has to be amortized for the time the bonds are outstanding. Quick and dirty, for Year 1, cash paid is $7,000, interest expense is $6,208 ($103,465 x .06), and the premium amortized is $792 ($7,000 – $6,208). For Year 2, cash paid remains $7,000, interest expense is $6,160 [(103,465 – 792) x .06], and the premium amortized is $840 ($7,000 – $6,160).
And so on for Years 3 and 4.
Corporations raise money to purchase assets in one of two ways: debt or equity.
Oddly enough, debt can end up making a company money. This is called financial leverage, and it takes place when the borrowed money is expected to earn a higher return than the cost of interest payable on the debt. Additionally, interest expense on debt is a tax deduction, whereas dividends payable to investors are not.
Based on many factors that combine advanced financial accounting and finance, the company may also end up in a better position due to the decrease in taxes payable.
