What it means
A bond trades below face value when its coupon is lower than what investors currently demand, or when the issuer's credit has weakened. Buying at a discount means part of the investor's return is the pull towards face value at maturity rather than the coupon.
Accounting will not let that gain sit unrecognised until the final day. Instead the discount is recognised in instalments over the remaining life, increasing interest income for a holder or interest expense for an issuer, and increasing the carrying amount of the instrument.
This matters because reported yield would otherwise be misleading. Without accretion, a bond bought at $92,000 that pays a 5% coupon would look like a 5% investment, when the true return also includes $8,000 of gain to be collected at maturity.
The preferred technique is the effective interest method. You apply the yield implied by the purchase price to the opening carrying amount, treat the difference between that figure and the cash coupon as the accretion, and add it to the carrying amount.
A simpler straight-line approach divides the discount evenly across the remaining periods. It is acceptable when the result is not materially different, and it is common in smaller entities and in teaching examples because the arithmetic is obvious.
The mirror image is amortisation of premium, where a bond bought above face value has its carrying amount written down over time. Both mechanisms exist for the same reason: to make reported interest reflect the real economics of the price paid.
In practice
Real-world examples.
Example
A pension fund buys corporate bonds at 94 cents on the dollar. Its accounts show interest income above the coupon rate each year because the discount is accreted, which is why its reported yield exceeds the stated coupon.
Example
A company issues bonds at a discount because it set the coupon below market rates. Its income statement carries interest expense higher than the cash coupon, and the bond liability grows each year until it equals the redemption amount.
Example
A treasury team buys short-dated bills at a discount with no coupon at all. The entire return is accretion, recognised evenly across the 180 day holding period rather than as a gain on the day the bill matures.
Formula
Calculation
Straight-line: Annual accretion = (face value - purchase price) / years to maturity. Effective interest: Accretion = (opening carrying amount x effective yield) - cash coupon received.
An insurer buys a bond with a face value of $100,000 for $92,000, with four years to maturity and a 5% annual coupon of $5,000.
Straight-line: total discount = $100,000 - $92,000 = $8,000, so annual accretion = $8,000 / 4 = $2,000. Interest income in year 1 = $5,000 coupon + $2,000 accretion = $7,000, and the carrying amount rises to $92,000 + $2,000 = $94,000.
Under the effective interest method the yield implied by the $92,000 price is 7.38%, so year 1 interest income = $92,000 x 7.38% = $6,790. Subtracting the $5,000 cash coupon gives accretion of $1,790, and the carrying amount becomes $92,000 + $1,790 = $93,790, a slightly slower start than the straight-line result.Case study
Seen in the real world.
Ashcombe Mutual is an invented insurance company used here as an illustrative example. Its investment team bought $10,000,000 of face value bonds for $9,200,000 with four years left to run, pleased at the bargain, and initially reported only the cash coupons as income.
The auditors flagged that the $800,000 discount had to be accreted, adding about $200,000 a year to reported investment income on a straight-line basis. That correction raised reported profit in each of the four years, which sounds pleasant until you notice the flip side: the gain everyone had been mentally saving for maturity had already been recognised by the time the cash arrived.
The finance director used the episode in this fictional case to retrain the team on total return. Comparing bonds on coupon alone had been steering the portfolio towards high-coupon issues bought at premiums, where the accounting works in exactly the opposite direction.
Watch out
Common mistakes.
- Recording the full discount as a gain on the maturity date, when it should have been recognised as interest across the whole holding period.
- Judging a bond by its coupon rate alone, when a discounted purchase means the effective yield is higher than the coupon suggests.
- Using straight-line accretion on a long-dated instrument where the effective interest result differs materially, which distorts reported income in the early years.
Questions
People also ask.
Is accretion of discount a cash item?
No, it is a non-cash accounting entry, which is why it is added back or adjusted for when reconciling profit to operating cash flow.
How does it differ from accreted value?
Accretion of discount is the periodic amount recognised, while accreted value is the resulting running balance of the instrument.
What happens if the bond is sold before maturity?
The carrying amount at the sale date already includes accretion to date, and any difference between that amount and the sale proceeds is a gain or loss on disposal.
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