What is Premium?
In Finance, Premium is the value in excess with the nominal value. It is extra value that the customer is ready to pay. This value is paid by the customer to enjoy the higher quality product or service. Example- Premium on Limited Edition watches, Premium on shares etc
Face value: It is the nominal value assigned to an instrument. For stocks its the initial value when the share is issued.
Redemption value: The amount to be received when a financial instrument repaid on its maturity.
Premium on redemption: Premium on redemption of debentures/ preference shares is the amount paid to the debenture holders/ preference shareholders in excess of face value of debentures/ shares, at the time of redemption.
Formula of Premium on redemption = Redemption value- Face value
Lets assume that company X issued debentures of face value Rs. 100 per debenture due for redemption after 10 years at a premium of Rs. 5 per debenture.
In this case, the redemption value payable by company X to its debentureholder at the end of 10 years is Rs. 105. This redemption value of Rs. 105 when splitted in to two i.e. 100(Principal value) + 5(Premium), shows that the company actually has to pay out only Rs. 5 on account of premium from its profits or earnings. The remaining sum of Rs. 100 is the principal investment returned back to the debenture holder. The outflow of this amount will occur after the said 10 years have elapsed and not at the moment.
Accounting treatment
The accepted accounting treatment of this expenditure incurred through payment of premium on redemption of debentures will be done through allocation of the total expenditure incurred in this regard over the period during which the company generates the income by investing the amount received from debentureholders in its business.
Therefore in the above case, expenditure of Rs. 5 per debenture will be written off as expense over the period of 10 years and proportionate amount will be debited to P&L A/c of the entity every year on provisional basis. Further suppose that 10000 debentures are issued. Then the expenditure in respect of premium on debentures will amount to Rs. 50000 (i.e. 10000 debentures x Rs. 5). This amount of Rs. 50000 when allocated over 10 years, the amount to be debited to P&L A/c every year comes to Rs. 5000 (50000/10).
Now, the amount of Rs. 5000 which is shown on the debit side of P&L A/c is just an allocation of expense which will actually lead to cash outflow in the years to come and not in the current year itself.
Conclusion- The amount of premium on redemption of debentures ultimately turns out to be a non-cash expense for the year in which it is debited to P&L A/c. And since this expenditure does not include any cash outflow it is added back while preparing cash flow statement while following indirect method, like other non cash expenses including depreciation, Amortization etc.
Also, the treatment for the premium on redemption of preference shares is similar to above treatment.
Thanks for reading. Comment for more questions.
Author Bio
