Accretion: Definition & Overview
You can succeed or fail based on the financial health of your company and if you want to effectively address the shifting difficulties your firm encounters, your grasp of finance will have to expand along with it.
Accrual appears to be a term used exclusively by brokers, day traders, and experienced investors. But for the sake of your company and its stockholders, it might be useful to comprehend this concept.
So what exactly is accretion? How do we determine what constitutes accretive behavior? And how would this knowledge help your business?
Read on as we take you through what accretion is, look at it in the context of bond markets, mergers, and acquisitions, and provide you with an example.
Table of Contents
- Accretion for account has two different methods of calculation. The straight line method and the constant yield method.
- The straight line method is simpler of the two, and the increases are evenly distributed over the term. Whereas the constant yield method increases closest toward the bond’s maturity.
- Although the bond can be purchased at par, discount, or premium, the overall value is at par when the maturity date arrives.
- Accretion for investors tells them what the amount of discount they’re getting on the bond.
- For mergers/acquisition, it helps the buyer determine if the merger/acquisition is beneficial or not.
What is Accretion?
In finance, accretion refers to the gradual increase in the value of a company over a period of time through acquisition, mergers, or expansion. Accretion has two different applications. It’s present in both corporate finance and accounting.
In accounting, accretion is the gains that an investor realizes through the purchase of a bond at a discount. Capitalizing on the discount means they must account for gains on the bond when the maturity date comes around.
Accretion in Bond Market
When the price of a bond falls below its par value or current market value (CMV) and an investor purchases the bond, it’s considered to be purchased at a discount. So when the investor gets the full value of the bond at maturity, it profits from the accretion discount issued on the bond.
For example, if an investor buys a $1000 bond from a company for a below CMV price of $750, they would have an accretion discount of 25% assuming that this is a zero-coupon bond. As the bond approaches maturity, the value increases incrementally until it reaches its par value.
If a bond is purchased at a premium or higher than its par value, the opposite happens. Instead of the value increasing to meet the par value, the value depreciates over time to reach the same par value upon maturity. This type of decrease in value is also referred to as an amortization of premiums.
Methods of Bond Accretion
There are two separate methods of accounting for bond accretion. The straight line method and the constant yield method. Let’s take a look at how each one functions.
Straight line method
The straight line method is the easier one to understand. Across the bond term, the value of the bond increases evenly over the total number of periods within the term.
For example, on a ten year bond, the issuing business reports their finances each quarter. With four quarters in a year, you multiply that by 10 years to get the total number of periods. That equals 40 financial periods until the bond reaches maturity.
If a $5,000 bond is purchased at a discount of 15% then the $750 accretion would be divided amongst 40 financial periods. So each quarter the bond holder would see an increase in value of $18.75 until the bond reaches its par value.
Constant yield method
This method doesn’t result in even distributions across time periods. Instead, the bond’s value increase is more heavily focused toward the end of the bond maturity date.
To use the constant yield method, you start by finding the Yield To Maturity (YTM). The YTM is basically the total anticipated rate of return on a bond if it’s held until maturity and it’s expressed as a percentage. YTM is also dependent on how frequently the yield is compounded.
Once you have that you plug it in to the following formula:
Let’s say that an investor purchased a bond at $90 and the current market value is $150 with a maturity of 5 years. The company releases financial reports annually so there’s only one accrual period per year. The YTM is 12.133% and there’s 1% coupon interest on the par value. All in all, it would look like this:
- $90 x 12.133% =10.91
- 91-1.50 = 9.41 accretion amount for period 1
For subsequent accrual periods, you would take the accretion amount found in the first period of 9.41 and add it to the purchase price. For example:
- ($90+$9.41) x 12.133% = 12.06
- 06-1.50= 10.56 accretion amount for period 2
Accretion in Mergers & Acquisition
During mergers and acquisitions, accretion works a little differently. The company acquiring the other would add the EPS of the company being purchased into their own EPS.
For example, Company A has state earnings of $3 million. They have 1 million outstanding shares. Company B has $1 million in earnings and 500,000 outstanding shares.
Company A: 3,000,000/1,000,000= $3 EPS
Company B: 1,000,000/500,000= $2 EPS
Combined: 4,000,000/1,500,000= $2.66 EPS
Overall, accretion can apply to many different scenarios. It’s useful to investors, the accounting field and companies looking to expand. In the bonds market, investors can confidently determine whether they will profit at the bond’s maturity date. Higher accretion implies a larger discount. For companies, accretion is helpful for figuring out whether an merger/acquisition makes financial sense or not. When accretion is high, it’s a signal to move forward or increase the bid offer to close the deal faster to reap the benefits.
FAQs About Accretion
What does accretion mean in finance?
In finance accretion refers to the gradual increase in the value of a company over time.
What are accretion and amortization?
Accretion and amortization are similar in some respects. Amortization just refers to the incremental amount of increase or decrease in value over time. Accretion does something similar when used for bonds.
Is bond accretion taxable?
Yes, it is taxable, but the IRS allows you to choose which method of accretion to use. You should always consult a tax professional when considering your taxable income.
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