When a lender funds $98m on a $100m loan, the $2m discount is part of its return. But it doesn't collect that $2m on day one; it collects it at the end, when the borrower repays $100m. So when should the fund count it as income?
Accounting answers: gradually, over the loan's life. This lesson shows how, using the Alder Ridge Logistics loan from PC101 3.3, and explains what happens when a loan is repaid early. It matters because OID accretion is part of the interest income a credit fund reports, and a large part of its yield.
Why OID is spread out
PC101 3.2 introduced original issue discount (OID): the lender funds less than the face amount, and the borrower repays the full amount. Upfront or closing fees paid by the borrower work the same way economically, and are commonly treated the same way in the accounts.
Under common accounting treatments, OID and these fees are recognized as interest income over the life of the loan, not when the loan is made. The logic is that they're part of the price of lending, earned as the lender keeps its money in the loan.
Each period, the fund:
- records interest income,
- of which part is the cash coupon it receives, and
- the rest is OID accretion, which increases the loan's amortized cost.
Amortized cost starts at the amount funded ($98m) and rises toward the face amount ($100m) as the discount is accreted.
The effective interest method
The effective interest method finds the single rate, the effective interest rate, at which the loan's expected cash flows are worth exactly what was paid. Each period's interest income is the opening amortized cost × that rate. The difference between that income and the cash coupon is the OID accreted.
The following example is illustrative and simplified. It treats the Alder Ridge loan as paying interest once a year and holds SOFR flat at 4.00%, so the cash coupon is fixed at 9.25% of $100m, or $9.25m a year. Real loans pay quarterly and float; see "In practice" below.
| Input | Value |
|---|---|
| Face amount | $100.0m |
| Amount funded (issued at 98) | $98.0m |
| OID | $2.0m |
| Cash coupon | $9.25m a year |
| Contractual term | 5 years |
| Effective interest rate | about 9.77% (9.7746% to four decimals) |
The effective rate is the rate at which $9.25m a year for five years, plus $100m at the end, is worth $98m today. It's found with a spreadsheet's rate function, not by hand.
Accretion table ($m):
| Year | Opening amortized cost | Interest income (× 9.7746%) | Cash coupon | OID accreted | Closing amortized cost |
|---|---|---|---|---|---|
| 1 | 98.000 | 9.579 | 9.250 | 0.329 | 98.329 |
| 2 | 98.329 | 9.611 | 9.250 | 0.361 | 98.690 |
| 3 | 98.690 | 9.647 | 9.250 | 0.397 | 99.087 |
| 4 | 99.087 | 9.685 | 9.250 | 0.435 | 99.522 |
| 5 | 99.522 | 9.728 | 9.250 | 0.478 | 100.000 |
| Total | 48.250 | 46.250 | 2.000 |
Figures are rounded; the total accretion is exactly the $2.0m of OID, and amortized cost ends at the $100m face amount. Notice that accretion grows each year, because the rate is applied to a rising amortized cost.
The straight-line shortcut
The straight-line method simply spreads the OID evenly: $2.0m ÷ 5 years = $0.400m a year.
| Year | Effective interest | Straight-line |
|---|---|---|
| 1 | 0.329 | 0.400 |
| 3 | 0.397 | 0.400 |
| 5 | 0.478 | 0.400 |
Straight-line recognizes income a little faster early on. Both reach the same $2.0m in total. Some funds use straight-line where the difference is small, as their accounting policies allow; the effective interest method is the more precise approach.
When the loan is repaid early
Most private loans are repaid before maturity (PC101 3.3). When that happens, the accretion schedule stops, and any OID not yet accreted is commonly recognized as income at repayment.
Illustratively, if Alder Ridge repays the whole loan at the end of year 1 at 102:
| Item | Amount |
|---|---|
| OID accreted in year 1 | $0.329m |
| Unamortized OID recognized at repayment | $2.000m − $0.329m = $1.671m |
| Prepayment premium (2% × $100m) | $2.000m |
So a repayment can add a lump of income in the quarter it happens. This is one reason reported portfolio yields can jump in quarters with many repayments, as PC101 3.3 noted from the pricing side. Fund reports and analysts often point these one-off items out.
In practice
- Floating rates. Because the coupon changes with SOFR, the effective rate is commonly recalculated or approximated as rates reset. Loan and accounting systems handle this automatically.
- Frequency. Accretion is recorded each period the fund closes its books, often monthly or quarterly.
- Fair value funds. Investment funds that carry loans at fair value (PC101 4.2) still track amortized cost. Interest income, including accretion, is measured from amortized cost; the difference between fair value and amortized cost shows up as unrealized gains or losses.
- Policies differ. Exact treatments depend on the accounting framework (such as US GAAP or IFRS) and each fund's policies. Your fund's accounting policy manual is the reference.
Key terms
- Original issue discount (OID): The difference between a loan's face amount and the amount the lender funds.
- Amortized cost: The amount funded plus OID accreted to date (less any repayments); it rises toward face value.
- OID accretion: The part of interest income that comes from spreading the discount over time.
- Effective interest method: Recognizing income at a constant rate on amortized cost.
- Effective interest rate: The rate at which a loan's expected cash flows equal the amount funded.
- Straight-line method: Spreading OID evenly over the loan's term.
Key takeaways
- OID and upfront fees are commonly recognized as income over the loan's life, not on day one.
- Under the effective interest method, income = opening amortized cost × effective rate; accretion is income minus the cash coupon.
- Straight-line spreads OID evenly and is a common simplification where the difference is small.
- On early repayment, unamortized OID is commonly recognized as income, alongside any prepayment premium.
- Funds at fair value still use amortized cost to measure interest income.
This lesson is for educational purposes only and is not investment advice.