Accretion of discount definition
/What is Accretion of Discount?
Accretion of discount is the ongoing increase in the value of a discounted security as its maturity date approaches. As an example, an investor buys a bond at a discount, where the purchase price is $950 and its face value is $1,000. Because the issuer will pay the full $1,000 face value on the maturity date of the bond, its value will gradually increase between the purchase date and the maturity date. This gradual increase in value is called accretion of discount.
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Accounting for Accretion of Discount
Accretion is recorded through a series of accounting entries over the remaining life of the bond. There are two approaches for doing so, which are noted below.
Straight-Line Accretion of Discount
Under the straight-line method, a standard amount of the discount is added back to the bond value each month. For example, suppose an investor buys a bond for $950, but its face value (the amount to be paid at maturity) is $1,000. The bond matures in 5 years, meaning the investor will earn a $50 gain over the life of the bond. Using the straight-line method, the investor accretes the $50 discount evenly over the 5 years. The annual accretion is calculated as follows:
$50 ÷ 5 years = $10 per year
Each year, the carrying value of the bond increases by $10. The resulting accretion appears in the following exhibit.
Constant Yield Method of Discount Accretion
Under the constant yield method, you re-calculate the amount of interest income in each successive period, based on the current carrying amount of the bond and the effective interest rate. The interest income in each period is then added to the carrying amount of the bond. This means that the rate of increase in bond value is greatest near the maturity date.
The constant yield method is more theoretically accurate than the straight-line method, but is more difficult to calculate.