Accretion refers to a gradual increase in the value of assets or earnings over time. Investors widely use it to identify lucrative investment opportunities with long-term growth potential. Also, it helps investors to strategically rebalance the portfolio and optimise its overall return. Let us understand this concept and its practical application in detail.
What is the meaning of accretion?
In the context of finance and accounting, accretion represents the gradual increase in the value of an asset or liability over time. This increase typically occurs due to factors such as:
- Accrued interest
- Capital appreciation, or
- Addition of new assets
Accretion often applies to fixed-income securities such as bonds and loans, and the earnings of an organisation. Let us see how:
| Bond accretion | Loan accretion | Earnings accretion |
| At maturity, the price of a bond adjusts from its initial purchase price to its face value.This adjustment is usually driven by:Accrued interest andConvergence of market price towards par value | Loans or debt instruments issued at a discount experience accretion.This happens due to the discount getting amortised over the loan's life, which increases the carrying value of the debt. | The earnings per share (EPS) of a company increases from strategic transactions such as:MergersAcquisitions, orInvestmentsAs the organisation continues to achieve economies of scale:The profitability increases on a per-share basis andThe shareholder’s value surges |
Some other applications
Accretion also applies to assets and liabilities involved in:
- Purchase accounting and
- Fair value accounting
Let us understand both of them individually
| Accretion in purchase accounting | Accretion in fair value accounting |
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Understanding accretion
At its core, accretion is based on the compounding effect. For instance, bond accretion occurs as the bond's value increases towards its face value over time due to the accrual of interest.
Several factors influence accretion rates and are contingent upon the nature of the asset or liability in question. Some common factors that influence the pace of accretion are:
- Interest rates
- Market conditions, and
- Economic trends
Now, let us understand the influence of each of these factors
Interest rates
- When interest rates go up, the rate at which accretion occurs accelerates.
- That is because newly issued bonds have higher coupon rates.
- This new issue makes existing bonds with lower rates less sought after.
- Conversely, when interest rates fall, accretion rates slow down as the bond's yield decreases.
- This event affects a bond’s market value and the pace at which it accretes towards par value.
Market conditions
- The market conditions that influence accretion rates are:
- Supply and demand dynamics
- Investor sentiment, and
- Liquidity
- In bullish market conditions, bond prices increase more quickly, which leads to accelerated accretion.
- Conversely, in bearish market conditions, accretion rates slow down as bond prices stagnate or decline.
Economic trends
- Some common economic trends influencing accretion are:
- Inflation rates
- GDP growth, and
- Employment figures
- In periods of economic expansion, higher inflation and robust growth results in faster accretion.
- Conversely, during economic downturns, lower inflation, and slower growth results in slower accretion.
What is factoring in bond accounting?
In bond accounting, factoring refers to the impact of changing interest rates on the valuation of bonds. Let us understand factoring considering a situation when interest rates increase:
- When interest rates go up, existing bonds become less valuable.
- This effect is felt more by the bonds issued at a discount.
- A surge in interest rates causes the prices of existing bonds to fall.
- However, bonds are supposed to be paid back at their face value
- This difference between the current market price and face value is spread out following the process of accretion
- Accretion ensures that the bond's value gradually goes up until it reaches its face value at maturity
What is the meaning of bond accretion in finance?
As discussed earlier, bond accretion represents the gradual increase in the value of a bond over time as it approaches maturity. This increase in value occurs because:
- The bondholder accrues interest income and
- The bond's market price adjusts towards face value as the maturity date approaches
- It must be noted that the concept of bond accretion is particularly relevant for bonds purchased at a discount or premium to their face value.
How to calculate bond accretion?
You can calculate bond accretion following the straight-line method. It calculates bond accretion by evenly spreading the discount or premium over the remaining life of the bond.
Formula:
Let us understand better using a hypothetical example:
- Mr A purchases a 10-year bond with a face value of Rs. 1,000 at a discount price of Rs. 900.
- The bond pays annual interest at a rate of 5%.
Using the straight-line method for bond accretion calculation:
Accretion = (1,000 - 900)/ 10 years
Accretion = Rs. 10 per year
As demonstrated in the above example, the value of a 10-year bond will keep increasing annually by Rs. 10 until it reaches its face value of Rs. 1,000.
What is the meaning of earnings accretion in accounting?
Earnings accretion refers to the increase in a company's earnings per share (EPS). This surge usually happens following a strategic transaction, such as a:
- Merger
- Acquisition, or
- Investment
What does it tell you?
Earnings accretion shows the extent to which the strategic transaction contributes positively to the acquiring company's:
- Earnings and
- Overall profitability on a per-share basis
It provides insights into the value-creation potential of strategic transactions.
How can you apply earnings accretion in financial statement analysis?
Let us understand the practical application following a step-by-step guide:
Step I: Identify strategic transactions:
Identify the strategic transactions such as mergers, acquisitions, and investments.
Step II: Gather financial data
Collect relevant financial data from the company's financial statements, including:
- Income statements
- Balance sheets, and
- Statements of cash flows
Ensure that you have access to both pre-transaction and post-transaction financial information.
Step III: Calculate pre-transaction EPS
Calculate the earnings per share (EPS) for the period before the occurrence of the strategic transaction.
Use this formula:
Pre-transaction EPS = Net income / Weighted average number of shares outstanding
Step IV: Calculate post-transaction EPS
Calculate the earnings per share (EPS) for the period after the occurrence of the strategic transaction.
Use this formula:
Post-transaction EPS = (Net income + Incremental earnings) / Weighted average number of shares outstanding
Step V: Compare pre- and post-transaction EPS
Compare the pre-transaction EPS with the post-transaction EPS.
Determine the change in EPS resulting from the strategic transaction.
Step VI: Interpret comparison results
If the post-transaction EPS is higher than the pre-transaction EPS, it indicates earnings accretion.
Earnings accretion example
- Company A acquires Company B for Rs. 50,00,000, financed through cash and stock.
- Following the acquisition, Company A's EPS increased from Rs. 2 to Rs. 2.20 per share due to the incremental earnings generated by Company B.
- This Rs. 0.20 increase in EPS represents the earnings accretion resulting from the acquisition.
Conclusion
In essence, accretion means the gradual increase in the value of assets or earnings over time. By understanding accretion, you can make informed investment decisions and develop value-creation plans.
Accretion primarily applies to bonds issued at a discount, debt, and earnings of a company. Having a deep understanding can help you identify opportunities and achieve sustainable growth in the ever-changing world of finance.
