A company issued 10-year, 9%, $1,000,000 bonds paying interest on an annual basis, at a premium. Which one of the following statements is true?

Question

Quizplus · Accepted Answer

When a company issues bonds at a premium, it means that the bonds are sold for more than their face value. In this case, the face value of the bonds is $1,000,000, and since they are issued at a premium, the issue price is more than $1,000,000.
The annual interest payments to bondholders are based on the face value of the bonds and the stated interest rate. For these bonds, the annual interest payment is 9% of $1,000,000, which equals $90,000.
However, the interest expense reported on the company's income statement is not simply the annual interest payment. Instead, it is calculated using the effective interest method, which takes into account the amortization of the bond premium over the life of the bonds. The bond premium is the difference between the issue price and the face value of the bonds. Since the bonds were issued at a premium, this premium is amortized over the life of the bonds, which reduces the annual interest expense recognized on the income statement.
Therefore, even though the company pays $90,000 in cash as interest to bondholders each year, the interest expense recognized on the income statement will be less than $90,000 because it includes the effect of the premium amortization.
The other statements are incorrect based on the following:
a. The annual interest expense on the bonds will not be greater than the amount of interest payments to bondholders each year because the bonds were issued at a premium, not a discount.
c. The issue price will not be less than $1,000,000 because the bonds were issued at a premium, which means they were sold for more than their face value.
d. The cash paid to bondholders is based on the stated interest rate of the bonds (9% in this case), not the market rate of interest. The market rate of interest affects the issue price of the bonds (whether they are sold at a premium or discount), but once the bonds are issued, the cash payments are fixed and based on the stated rate.

A Company Issued 10-Year, 9%, $1,000,000 Bonds Paying Interest on an Annual