What it means
Most bonds pay regular interest called a coupon and return the face value at maturity. Some, such as zero-coupon bonds, pay no coupons at all and are sold at a deep discount instead.
An investor who buys a $1,000 bond at $600 receives the $1,000 at maturity, and the $400 gain is the original issue discount. The discount is a form of interest that the investor earns over time but receives only at maturity.
Accounting and tax rules therefore require it to be spread over the years the bond is held. The amount recognised each year is called accretion, and it increases the carrying value of the bond until it reaches face value.
In the United States, the investor generally has to include the accrued discount in taxable income each year, even though no cash is received. This is sometimes called phantom income because the tax bill arrives before the money does.
Many investors hold OID bonds in tax-deferred accounts or choose them for children's savings for this reason. For the issuer, the discount is a financing cost that is expensed gradually, and it may be deductible.
The tax rules usually use a constant-yield method, which applies the bond's yield to its carrying value each year. A simpler straight-line method is sometimes used for illustration or where the rules allow.
OID also arises in loans. A lender may advance $9,800,000 and require repayment of $10,000,000, with the $200,000 difference treated as discount.
Finance teams must record it correctly, since it affects interest expense, reported profit and the cash tax position.
In practice
Real-world examples.
Example
An investor buys a zero-coupon bond for $5,000 with a face value of $10,000 due in 15 years. The $5,000 discount is her return. She includes a portion of it in her taxable income each year, even though she receives nothing until maturity.
Example
A corporation issues $50,000,000 of five-year notes at 96% of face value. The company receives $48,000,000 and records a discount of $2,000,000. It spreads this as additional interest expense over the five years.
Example
A lender gives a small business a loan of $9,800,000 that must be repaid at $10,000,000. The $200,000 difference is recognised as interest income over the life of the loan. The lender's accountant sets up a schedule to record the amount each month.
Formula
Calculation
OID = redemption value (face value) - issue price
A company issues a 10-year zero-coupon bond with a face value of $1,000 at an issue price of $600. OID = 1,000 - 600 = $400. Under a straight-line approximation, the discount accrues at 400 / 10 = $40 a year. Under the constant-yield method the bond's yield is about 5.24%, so year one accretion is roughly 600 x 0.0524 = $31, rising in later years as the carrying value grows.Case study
Seen in the real world.
Trident Infrastructure is a fictional company used to illustrate original issue discount. In this illustrative story, it issued $100,000,000 of 10-year zero-coupon bonds at $62,000,000 to fund a toll road. The OID was 100,000,000 - 62,000,000 = $38,000,000, and the company did not have to make any cash interest payments for a decade.
The finance team recorded the accretion as interest expense each year, which reduced reported profit even though no cash left the business. Because interest was deductible, the company also reduced its cash tax bill. At maturity it had to find $100,000,000 in cash, so it set aside funds in a sinking fund over the final years.
An early investor in the bonds, a fictional pension fund, held them without difficulty because it paid no tax. A private investor who bought the same bonds in a taxable account noted the phantom income and moved them into a retirement account. The two investors illustrate how the same discount can have very different consequences.
Watch out
Common mistakes.
- Thinking the discount is a capital gain only at maturity. For tax purposes it is often treated as interest that builds up each year.
- Forgetting that tax may be due before cash arrives. Holders of OID bonds should plan for the bill, particularly in taxable accounts.
- Using straight-line accretion when rules require constant yield. The two methods give different yearly amounts.
Questions
People also ask.
What is a zero-coupon bond?
It is a bond that pays no regular interest and is sold at a discount to its face value.
Is OID the same as a market discount?
No. OID arises when a bond is first issued below face value, while a market discount arises when a bond is bought later at a price below face value.
Who records OID in the accounts?
The issuer records it as a financing cost, and the investor records it as interest income, both spread over the life of the bond.
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