What Is Accretion?
Accretion is the gradual and incremental growth of assets and earnings due to business expansion, a company’s internal growth, or a merger or acquisition.
In finance, accretion also refers to the accumulation of additional income that an investor expects to receive after purchasing a bond at a discount and holding it until maturity. Notable examples of financial accretion include zero-coupon bonds and cumulative preferred stock.
Key Takeaways
- Accretion involves the steady and incremental growth of assets.
- In finance, it signifies the extra income an investor anticipates from bonds bought at a discount and held to maturity.
- The accretion rate is established by dividing a bond’s discount by the number of years until its maturity.
Insights into Accretion
In corporate finance, accretion represents value creation through organic growth or acquisition. This happens, for example, when new assets are acquired at a discount, meaning below their perceived current market value. Accretion can also occur by acquiring assets expected to appreciate post-transaction.
When bonds are purchased below their face value in securities markets, it is observed as buying at a discount, whereas purchases above face value are known as buying at a premium. In financial terms, accretion adjusts the cost basis from the purchase amount (discount) to the anticipated redemption amount at maturity. As an example, buying a bond for 80% of its face value leads to a 20% accretion.
The Role of Bond Accounting
When interest rates rise, the value of existing bonds falls, resulting in market price declines to reflect these interest rates. As all bonds mature at their face value, an investor earns additional income on bonds purchased at a discount. This additional income is recognized through accretion.
Case Study: Bond Accretion
Consider an investor buys a $1,000 bond for $860, maturing in 10 years. From purchase to maturity, the investor must recognize an additional income of $140. This $140 is recorded as a discount on the bond account initially; over the next decade, portions of the $140 are reclassified into the bond income account annually, fully posting the $140 to income by maturity.
Accretion in Earnings
The earnings-per-share (EPS) ratio is earnings available to common shareholders divided by average common shares outstanding. Accretion thus reflects an increase in a firm’s EPS due to acquisitions. The accreted value of security, however, may not always relate directly to its market value.
Practical Examples of Accretion
Example 1: Corporate Earnings Accretion
Assume a firm generates $2,000,000 in earnings for common shareholders with 1,000,000 shares outstanding, resulting in an EPS ratio of $2. By issuing 200,000 shares to acquire a company that brings in $600,000 in earnings for common shareholders, the new EPS for the amalgamated companies is $2.17, calculated by dividing $2,600,000 in earnings by 1,200,000 shares. This enhanced EPS is due to earnings accretion from the acquisition.
Example 2: Bond Purchase and Accretion
Imagine buying a $1,000 bond for $750, with a 10-year term. The bond, bought at a discount, pays out the initial investment plus interest upon maturity. For zero-coupon bonds, there is no periodic interest accrual, only payout at face value (or accreted value) upon maturity.
Example 3: Corporate Acquisition’s Impact
In corporate finance, envision Corporation X with an EPS of $100 acquiring Corporation Y, which has an EPS of $50. Post-acquisition, if Corporation X’s EPS rises to $150, the deal is 50% accretive, driving value enhancement.
Note: Long-term debt, like car loans, typically becomes short-term when the obligation reaches the final year before complete repayment. For instance, a five-year car loan shifts to a short-term category after the fourth year.
Related Terms: Zero-Coupon Bonds, Earnings-Per-Share (EPS), Discount, Mergers and Acquisitions, Preferred Stock.
