Bond premium amortization is a method in accounting that companies use to record the payments they make to bondholders above the face value of their bonds plus the interest payments. While the investors see no differentiation between interest and premium payments, companies must keep track of these differences. They ensure that the premium is repaid when the bond matures so that the payment stream is the one that was expected upon sale of the bond.
Companies issue bonds as a way of borrowing money from investors. They trade a series of payments for the purchase price that the investor pays. In traditional loan terms, the par or face value is the loan principal, while the coupon rate is the interest rate. In the final period, the company pays the investor the face value of the bond, which is similar to the way that individual borrowers must repay the entire principal of a loan in a balloon payment at the end of the payment stream on a non-amortizing loan.
Bonds are priced according to the present value of the future payments they promise. If the coupon rate is the same as the market interest rate, then the present value calculation will wash out with the interest, and the price will be the face value. If the coupon rate is below the market interest rate, the bond is less valuable, and it is said to be sold at a discount. If the coupon rate is higher, then the bond price is higher than the face value. The difference between the price and the face value is called the bond premium.
The bond premium is not accounted for in the traditional principal and interest construction, but it must be repaid. Instead of adding it to the principal, companies pay a portion of the premium as part of each coupon. This process is called bond premium amortization. For the investor, nothing changes as a result of bond premium amortization; bonds pay the coupons and face values laid out in their contracts regardless of whether they are sold at a discount or a premium. The corporation, however, must distinguish between interest payments and premium amortization on its account statements.
Often, bond premium amortization occurs because market interest rates change just before the release of a bond issue. Rather than rewrite the contracts, the company sells the bonds at a premium. Amortizing that premium avoids changing the terms of the bond to reflect the market rate. Bond premium amortization is commonly straight-line, which means that the same amount is amortized in each period.