Read to Know What is Accretion of Discount
Accretion of discount means that, over time, the value of a discounted security increases, as its maturity date approaches. In accounting terms, it is a process used to adjust the value of a bond which has been bought at a discounted price. The value of a financial instrument will accrete (i.e. grow) at an interest rate implied by the discounted issue price, the value, and the period to maturity.
Bonds can be purchased at par, premium, or a discount. However, irrespective of the bond purchase price, all bonds will mature at par, otherwise called Face Value. The par value is the amount that a bond investor will receive at maturity. Bonds purchased at a premium are worth more than their face value. The accretion of discount is used to adjust the book value of the bond, to its par value, at maturity. As a bond approaches maturity, the value of the bond decreases until it is at par on the maturity date. The decline in value over time is known as the amortization of premium.
The value of bonds issued at a discount is below those issued at par. As the bond approaches its maturity date, its value increases until it converges with the par value at maturity. This increase in value over time is defined as the accretion of a discount.
For example, a 3-year bond with a par value of INR 1,000 is issued at a discount of INR 975. Between issuance and maturity, the value of the bond increases until it reaches the face value of INR 1,000, which is the amount paid to the Bondholders at maturity.
Accounting treatment of accretion of discount
Generally, accretion of discount uses the following two methods of accounting:
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Straight-line method
In this method, accretion of discount is accounted for using a straight-line method, meaning the increase is evenly spread throughout the holding term. Using this method of portfolio accounting, accretion of discount is a straight-line accumulation of capital gains.
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Constant Yield method
Accretion of discount can also be accounted for using a constant yield method, whereby the increase is closest to maturity. Being a method required by the Internal Revenue Service (IRS) to calculate the adjusted cost basis, this is usually from the purchasing amount to the expected amount of redemption. Rather than the profits being paid when the bond reaches maturity, in this method, the gains are spread out over the remaining lifetime of the bond.
How constant yield method is calculated
The constant yield method uses the following formula to calculate the accretion of discount:
Accretion Amount = Purchase Basis x (YTM / Accrual periods per year) - Coupon Interest
When calculating the accretion of discount using this method, you first need to determine the yield to maturity (YTM). YTM is the yield or the profits earned on a bond that is held to maturity. Note that the yield to maturity (YTM) is highly dependent on how often the profit is compounded. The Internal Revenue Service (IRS) allows taxpayers flexibility in terms of determining which accrual period is best for their computing yield.
Example
Let’s consider an example. A bond has an INR 100 par value and a coupon rate of 2% is issued for INR 75, with a 10-year maturity period. Assuming annual compounding — YTM is calculated as:
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INR 100 = INR 75 x (1 + r)10
INR 100/INR 75 = (1 + r)10
1.3333 = (1 + r)10
r = 2.92%
The coupon interest on the bond is 2% x INR 100 par value = INR 2. Therefore,
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Accretion Period 1 = (INR 75 x 2.92%) – Coupon interest
Accretion Period 1 = INR 2.19 – INR 2
Accretion Period 1 = INR 0.19
The purchase price of INR 75 represents the bond’s basis at the time. However, over time, the basis becomes the purchase price plus accrued interest. For instance, at the end of year 2, the accrual can be calculated as follows:
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Accretion Period 2 = [(INR 75 + INR 0.19) x 2.92%] - INR 2
Accretion Period 2 = INR 0.20
This example clearly displays that a discount bond has a positive accrual. In other words, the basis accretes, increasing over time from INR 0.19, INR 0.20, and so on. It is an accounting process used to adjust the value of a financial instrument that was previously bought at a discounted rate.
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Frequently Asked Questions
Ans: When investors buy fixed-income securities, they often purchase them at a price above or below par value, depending on the market activity. Buying higher than face value is buying at a premium. Buying lower than face value is buying at a discount. Amortization and accretion calculations are used to adjust the cost basis from the purchase amount to the expected redemption amount. Instead of realizing the gain or loss in the year of the bond’s redemption, this spreads out the gain or loss over the remaining life of the bond. Amortization decreases cost and decreases income; whereas accretion increases cost and increases income. Accretion can be considered the antonym of amortization.
Ans: Accreted value is a bond's current value, including the interest accrued even though usually not paid until maturity. It is the value, at any given time, of multi-year security or instrument that accrues interest, but does not pay interest until maturity. The concept of accreted value can typically be seen in zero-coupon bonds or cumulative preferred stock.