Whether it’s an individual investor or a business owner looking to increase their earning power, understanding how accretion works is essential for individual and business investors to make the correct decisions going forward.
How Accretion Works for Bonds
Accretion is the gradual increase of a bond’s value over time. As a bond moves toward its maturity date, it increases in value until it reaches its face or par value – or what’s paid to the bondholder upon maturity.
If a bond has a face value of $2,000, yet it’s discounted at $1,900 when it’s offered for sale, the present value of the bond is $1,900, leaving the difference of $100 as the discount. Between the time of purchase and when it matures, the value of the bond will appreciate, up to its par value of $2,000. As the bond increases in value, this is referred to as an accretion discount.
When it comes to accounting for bond accretion, there are two common methods.
Straight-Line Method
This approach documents the bond’s appreciated monetary gain and is laid out equally over the bond’s time frame until maturity. For a bond with a term of 10 years and a business that publishes its earnings once a quarter, there are 40 earnings releases.
If there’s a $100 discount, spread across 40 quarters, that is $2.50 every three months. The $2.50 is the quarterly accretion until the bond matures.
Constant Yield Method
This method is different from the straight-line method in that the bond’s value appreciation increases in value closer to the bond’s maturity date.
Acquisitions and Accretion
Companies can also benefit from accretion. Through the concept of synergy, where there’s more output from combining multiple entities than the sum of them if still separate, an acquiring company adds the earnings before interest, taxes, depreciation, and amortization (EBITDA), for example, to add to its existing shareholders’ value.
Illustrating How it Works
If Company X wants to increase its earnings per share for its shareholders, an acquisition is one way to do so. Assume Company X earned $1 million in net income the preceding year and has 3 million shares. And then there is Company Z, which had $500,000 in net income over the same time frame, with 1 million shares issued to raise cash. The following is a way to calculate the acquisition accretion value of the new combined company.
Earnings Per Share of Company X: 1,000,000 / 3,000,000 = 0.33
Earnings Per Share of the new company post-acquisition: ($1,000,000 + $500,000) / (3,000,000 + 1,000,000) = $1,500,000 / 4,000,000 = 0.375
Based on the calculation, the earnings per share of the post-acquisition company are $0.375. Compared to the EPS for the original, pre-acquisition Company X, the post-acquisition company is $0.045, resulting in a positive acquisition accretion.
Whether an individual investor is looking to see how bond accretion works or a company is looking at whether an acquisition makes business sense, understanding how accretion works is essential to ensure it’s accounted for properly.
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