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
2
An 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.
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.
3
Due to the conservatism principle, contingent assets (gain contingencies) are not
recorded, and are disclosed only if highly probable.
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
x% * sub=s assets
CR
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
100% sub=s assets
CR
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
+
assets
cash
100
inventory 200
A/R
300
PPE
280
investment 20
total assets 900
liabs
A/P
LTDebt
O/E
tot liab +O/E
40% * Supply
=
8 DR
20 DR
20 DR
72 DR
(20) CR
100
200
200
500
900
consolidated B/S
108
220
320
352
1000
32 CR
68 CR
100
232
268
500
1000
Full Consolidation
Petroleum Equity Method
+
100% * Supply
=
consolidated B/S
assets
cash
100
inventory 200
A/R
300
PPE
280
investment 20
total assets 900
20 DR
50 DR
50 DR
180 DR
(20) CR
280
120
250
350
460
1180
liabs
A/P
LTDebt
80 CR
170 CR
280
370
200
200
external interest
O/E
tot liab +O/E
500
900
30 CR
280
30
500
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
revenue
1000
COGS
(800)
SG&A
(80)
interest exp
(20)
equity in sub=s NI 4
pre-tax earnings 104
tax expense
(40)
NI
64
+
40% * Supply
80
(56)
(10)
(7)
(4)
3
(3)
=
consolidated I/S
1080
(856)
(90)
(27)
107
(43)
64
+
100% * Supply
200
(140)
(26)
(17)
(6)
(4)
3
(7)
=
consolidated I/S
1200
(940)
(106)
(37)
(6)
111
(47)
64
Full Consolidation
Petroleum Equity Method
revenue
1000
COGS
(800)
SG&A
(80)
interest exp
(20)
external interest
equity in sub=s NI 4
pre-tax earnings 104
tax expense
(40)
NI
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
LTDebt/OE
ROA (NI/TA)
Equity method
200/500 = .40
64/900=.071
Proportionate Consol
268/500=.54
Full Consol
370/500=.74
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.