Professor Paul Zarowin - NYU Stern School of Business



Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Non-Current Liabilities: Bonds

The key feature of accounting for non-current liabilities, such as bonds (with or without coupons), is that their book values are always based on their original effective interest rate, i.e. the market yield in effect when they were first sold. Thus, changes in market interest rates subsequent to a bond=s issuance are ignored. Use of the historical interest rate is analogous to historical cost accounting for assets. Since the book values of liabilities are based on historical rates, whereas their market values are based on current rates, book values and market values will differ subsequent to issuance. As we will see, this creates the potential for income management by retiring bonds before their ultimate principal is due. Retirement can be by redemption (for cash) or by swapping the old debt for new debt or new equity.

When bonds are issued, if their coupon rate (annual cash interest ) par value of bond) does not equal their effective market rate, the bond will sell at a premium (above par, if coupon rate > effective market rate) or discount (below par, if coupon rate < effective market rate). The discount or premium is amortized over the life of the bond. The net book value (NBV) of the bond at any point in time is the par amount + unamortized premium (or - unamortized discount). The standard way to amortize the premium or discount is the effective interest method. In the effective interest method, interest expense = the effective interest rate x NBV of the bond; thus bond discounts and premia are amortized at this same rate, and NBV always equals [the remaining coupons + principal] discounted at the original effective rate. Note that since the cash coupon is given by the bond contract, and since the interest expense is calculated as shown above, the periodic amortization of the discount or premium is a plug.2

Early Retirement of Bonds

Retirement can be by redemption (for cash) or by swapping the old debt for new debt or new equity. The important point is that the bond is wiped off the books (DR=d) for its net book value, but the new consideration must be issued (CR=d) for the bond=s market value. This is because the old bondholders don=t care about the bond=s book value; they demand consideration equal to its market value. The entry is: DR CR

Old B/P - NBV

New B/P or C/S or cash (FMV)

Loss Or Gain

It is the use of historical interest rates that creates the difference between NBV vs FMV. If interest rates have risen since original issuance, FMV < NBV, and there is a gain. If interest rates have fallen since original issuance, FMV > NBV, and there is a loss. Since firms continually issue bonds, they have many vintages of B/P outstanding, some that risen in value, and some that have fallen. Thus, firms can pick which bonds to retire, thereby Amanaging@ income by choosing to recognize gains or losses. Gains or losses on early debt redemption are classified as extraordinary items.

Contingent Liabilities3

Contingent liabilities are liabilities resulting from a loss contingency, i.e., a possible future event. The most common types are litigation and environmental (superfund) liabilities. Accounting considers 3 degrees of probability: probable, reasonably possible, remote. A loss should only be recorded (DR to a loss account and CR to the liability) if the liability is probable and the amount of the loss can be reasonably estimated. If either (or both) condition is not met, the liability should be disclosed in a footnote, perhaps with a range or estimate.

Annual Report Disclosures about B/P

In their annual report footnotes, Companies must report the FMV of their outstanding B/P=s, and the annual principal repayments coming due for each of the 5 years subsequent to the B/S date. Companies must also disclose how much cash interest they paid during the year (not necessarily the same as annual interest expense on the I/S, as per the accrual principal). You can calculate an effective cash interest rate on the debt by dividing this cash payment by the firm=s outstanding debt (usually an average of beginning and end of year debt amount is used). You can then estimate how much cash interest payments will be over the next 5 years, by multiplying this rate by the amount of debt outstanding in each year, remembering to subtract the debt that will be redeemed. This is important information that can be compared to cash flow forecasts for the firm; i.e., will be projected cash flows be adequate to service the interest payments and the retiring debt, or must new securities be issued.

Keeping Debt off of the Balance Sheet - Equity Method Investments

Firms try to keep debt off the balance sheet, to make themselves appear less risky, as well for compliance with bond covenants. One way to do this is to use operating leases (see next section). Another way to do this is invest in subsidiaries using the equity method, rather than consolidate.

Accounting for investments under the equity method is used (generally) when the investment is in 20%-50% of the outstanding voting common stock. This percentage gives the parent influence, but not control, over the sub. Consolidation is used when the parent=s stake is greater than 50%; thus, control is achieved. The key accounting difference is that the equity method records only the net assets (owners= equity) of the sub as an investment (non-current asset) of the parent, ignoring the sub=s separate assets and liabilities. By contrast, consolidation recognizes the separate assets and liabilities (thereby haivng the same net effect on the parent=s owners= equity). Since under the equity method the separate assets and liabilities are each lower while owners= equity is unchanged (relative to consolidation), the ratio of debt-to-equity and debt-to-assets are lower (relative to consolidation). Since the equity method also reports the same net income as consolidation, ROA will be higher with the equity method, due to the lower total assets.

In order to achieve these reporting benefits of the equity method, firms may choose to make an investment of slightly less than 50% of the sub=s common stock (rather than greater than 50%), especially if such an investment can be made with sacrificing control of the sub. Control can be achieved with less tha 50% ownership, if the remaining 50+% of the shares are diffusely held. A classic example of such investment behavior is Coca Cola, which has a slightly less than 50% stake in its bottling subsidiaries. Coke keeps the subs= debt off of its balance sheet and raises its ROA by using equity method accounting.

Pro-Forma Consolidation when a firm uses the Equity Method: Proportionate vs Full Consolidation

Assume that the parent owns x% of the sub=s equity. This investment is an asset (DR balance) on the parent=s B/S. Thus, the external interest (equity owned by other parties) is (1-x)% of the sub=s equity.

Under proportionate consolidation, the parent consolidates only the x % of the sub=s assets and liabilities that it owns, and it does not recognize external interest. The consolidating journal entry is (note that the investment account gets eliminated by this entry):

DR CR

x% * sub=s assets

x%* sub=s liabilities

investment

Under full consolidation, the parent consolidates 100% of the sub=s assets and liabilities, and it recognizes external interest. The consolidating journal entry is (note that the investment account also gets eliminated by this entry; the external interest account gets created, as it did not exist before):

DR CR

100% sub=s assets

100% sub=s liabilities

investment

external interest

Now, let=s apply these two consolidation methods to the data for Petroleum and Supply in the handout. Petroleum, the parent, owns 40% of Supply, the subsidiary. Supply=s Owners= Equity is 50. Thus, Petroleum=s (equity method) investment is 40% * 50 = 20. We start with Petroleum=s equity method financial statements as given, and we apply proportional or full consolidation, as described above. Remember, that under both methods, 1. the Investment account gets eliminated, and 2. only the parent=s owners= equity appears on the consolidated B/S.

Proportionate Consolidation

Petroleum Equity Method + 40% * Supply = consolidated B/S

assets

cash 100 8 DR 108

inventory 200 20 DR 220

A/R 300 20 DR 320

PPE 280 72 DR 352

investment 20 (20) CR -

total assets 900 100 1000

liabs

A/P 200 32 CR 232

LTDebt 200 68 CR 268

O/E 500 - 500

tot liab +O/E 900 100 1000

Full Consolidation

Petroleum Equity Method + 100% * Supply = consolidated B/S

assets

cash 100 20 DR 120

inventory 200 50 DR 250

A/R 300 50 DR 350

PPE 280 180 DR 460

investment 20 (20) CR -

total assets 900 280 1180

liabs

A/P 200 80 CR 280

LTDebt 200 170 CR 370

external interest - 30 CR 30

O/E 500 - 500

tot liab +O/E 900 280 1180

Now that we have done the balance sheet, let=s do the income statement. Again, we start with Petroleum=s equity method financial statement, and we apply proportionate or full consolidation.

Note that Net Income is identical under all three methods, equity method, proportionate consolidation and full consolidation.

Proportionate Consolidation

Petroleum Equity Method + 40% * Supply = consolidated I/S

revenue 1000 80 1080

COGS (800) (56) (856)

SG&A (80) (10) (90)

interest exp (20) (7) (27)

equity in sub=s NI 4 (4) -

pre-tax earnings 104 3 107

tax expense (40) (3) (43)

NI 64 64

Full Consolidation

Petroleum Equity Method + 100% * Supply = consolidated I/S

revenue 1000 200 1200

COGS (800) (140) (940)

SG&A (80) (26) (106)

interest exp (20) (17) (37)

external interest - (6) (6)

equity in sub=s NI 4 (4) -

pre-tax earnings 104 3 111

tax expense (40) (7) (47)

NI 64 64

Now, let=s calculate some common ratios under all three methods. Note that since the parent=s NI and O/E are equal under all three methods, so too will ROE (ROE = NI )O/E) be equal.

Ratio Equity method Proportionate Consol Full Consol

LTDebt/OE 200/500 = .40 268/500=.54 370/500=.74

ROA (NI/TA) 64/900=.071 64/1000=.064 64/1180=.054

Note that as we move from equity method to proportionate consolidation to full consolidation, we recognize more and more of the Sub=s assets and liabilities. Since NI and O/E do not change, ROA falls and LTDebt/OE rises. These are some of the reasons firms try to use the equity method, rather than consolidate.

2An alternative method is straight-line (SL) amortization, which is often used if bonds are issued between coupon payment dates, because it is simpler to use than the effective interest method in this case. The SL method computes the monthly amortization evenly over the life of the bond. For example, if a 20 year (240 month) bond with semi-annual coupons is sold 4 months into the payment period, the premium or discount is amortized over 240 - 4 = 236 months. The first semi-annual interest payment 2 months after issuance includes 2 months of amortization, and all future six month periods include a full 6 months of amortization. Since the cash coupon is per the bond contract, and the amortization of the premium or discount is calculated by the SL method, the interest expense is a plug.

3Due to the conservatism principle, contingent assets (gain contingencies) are not recorded, and are disclosed only if highly probable.

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