BIWS 04-03 - More Advanced Accounting

What's the difference between the Face Value, Book Value, and Market Value of Debt?

Face value is the price at which a bond is initially issued. The only things that can change face value are principal issuances, repayments/maturities, and PIK interest. Face value is the amount that the firm pays interest on.

Book Value is the price at which a bond is held on a firm’s balance sheet. It is impacted by issuance fees, discounts, and premiums. Then, as these items are amortized back to par, that also impacts book value, as well as principal issuances.

Market value is the price at which a bond trades on the market. It is affected by supply and demand dynamics as well as the company’s credit quality

Why might a company issue Debt with an Original Issue Discount (OID), and how is it recorded on the statements?

Issuing at an OID increases the effective yield for investors since they get both the pull-to-par and the same interest income on a lower upfront investment.

This could be an attractive thing for a company to offer if they want to increase the demand for their debt. They may have to do this if their credit quality is poor, other bonds were issued into the market at higher interest rates than their stated one, or just overall supply and demand dynamics in the market do not favor the issuer.

The discount is deducted from the book value of debt on the balance sheet, and it amortizes over time so that the book value increases towards the face value of the bond at maturity. This amortization is recorded as an expense on the IS each year.

Why might a company continually record "Losses on Debt Extinguishment" on its statements?

There are a few ways a loss on debt extinguishment can occur. But, most commonly, if the issued debt still has unamortized issuance fees or an unamortized OID, then the fact that they have to repay at full par is going to require them to take a loss if they are repaying early.

Losses on the extinguishment of debt are non-cash, so they get reversed on the CFS and flow into the Book Value of Debt on the BS

How does a company record the initial issuance of a Convertible Bond on the statements

It can vary a bit between IFRS and GAAP.

Under IFRS, you have to split the issuance of the convertible bond into Liability and Equity components.

The liability is equal to the PV of future interest and principal repayments, which is discounted at a rate equal to the coupon on equivalent, non-convertible debt - it’s just what you’ll owe the creditor over the life of the bond

The equity component, then, is the Face Value of the convertible bond minus the liability component when it is first issued.

Under GAAP, the split only exists in the case of a cash-settlement option existing, but typically the option does exist.

What’s the accounting treatment if a Convertible Bond converts into shares before its maturity date?

If convertible bonds are converted to shares before maturity, you have to start by recording a loss on debt extinguishment for the unamortized issuance fees that still remain.

The Equity and Liability component, which is the book value of the debt after the amortization of issuance fees and the debt discount, and the losses on debt extinguishment, get transferred into CSE. This causes CSE to increase as both the equity and liability component of the convertible bond go to 0.

Explain the equity method of accounting (for equity investments or associate companies)

The equity method of accounting for investments is enacted when you own between 20% and <50% of the asset in which you are invested.

Under this method, you are considered to have meaningful say over the investment, meaning you don't record changes to the market value of it.

In practice, this means that the IS includes an addition to NI of your ownership % of the investment's NI. On the BS, you separately subtract the % of total dividends the company issued.

On the CFS, you then need to reverse the NI addition and separately add the dividends received, because in practice you get no cash from the NI, but you do get cash from the dividend.

Finally, on the BS, your investment account goes up by your % of NI and down by your % of dividends, while your equity changes by the net income addition only.

Explain consolidation accounting (for noncontrolling interests)

Consolidation accounting is used when you own 50% to less than 100% of a “subco”. In these cases, you fully combine your financial statements. A new line item gets created, though, which is noncontrolling interests. This line item appears on the IS as the % you don’t own * the total net income (“Net Income Attributable to Noncontrolling Interests”).

When you get to the CFS, you actually add-back the Net Income Attributable to Noncontrolling Interests, because it was a non-cash deduction on the IS — Sub Co.'s net income and cash were already fully consolidated elsewhere, so this line just reverses that allocation rather than reflecting cash the parent company keeps. At the same time, you have to first record a positive cash inflow for the Ownership Percentage * SubCo’s dividends, since that portion of Sub Co.'s dividend payment just goes back to Parent Co. as an intercompany transfer, before eventually subtracting the full amount of dividends from both Parent Co. and Sub Co. on the CFS as well.

On the BS, the cash change shows up in assets, while the Net Income and noncontrolling interests shows up in the Equity part. The noncontrolling interests line item is increased by the net income attributable to it, and decreased by the dividends attributable to it.

What happens on the financial statements when employees finally receive their shares from Stock-Based Compensation, and it becomes Cash-Tax Deductible to the company? Follow the U.S. GAAP treatment.

If the value of the shares has changed, then only the initial amount granted can help reduce the company’s cash taxes. This then shows up as a positive Deferred taxes adjustment on the CFS.

This fully reverses the DTA created on the BS when the SBC was issued.

On the IS, an additional line item appears for “Excess Tax Benefits/Deficiencies” in between pre-tax income and Net Income, which is equal to the change in value of SBC * Tax Rate

If the SBC’s value has increased, this line item reduces the company’s taxes; a decrease increases the tax burden.

Is this treatment for Stock-Based Compensation different under IFRS? Just give a high a level overview

The main IFRS difference revolves around the DTA. Under IFRS, the DTA associated with the initial issuance keeps changing. It still is created the same way and goes to $0 when the SBC becomes Cash-Tax Deductible

The initial “Tax Benefits” from the SBC, which is Tax Rate * Initial SBC Value, which is recorded on the IS between pre-tax income and NI, but the line item for Excess Tax Benefits is nonexistent.

Instead of that, under IFRS, Cash Taxes are reduced in the year the deduction is allowed, which writes DTA down to $0, which is the result of a positive adjustment in Deferred Income Taxes.

How are Unrealized Gains and Losses recorded differently for Trading / Fair Value Through Profit & Loss (FVPL), Available for Sale (AFS) / Fair Value Through Other Comprehensive Income (FVOCI), and Held to Maturity (HTM) / Amortized Cost securities?

All equity securities are accounted for using the Trading/FVPL treatment. Only debt securities can be recorded using AFS/FVOCI and HTM/Amortized Cost.

For equity securities, which use the Trading/FVPL treatment, unrealized gains and losses appear directly on the IS, but don’t affect cash taxes, so the deferred tax line item on the CFS changes, which links to the DTA or DTL on the BS. This impact is reversed when gain or loss is finally realized.

For AFS or FVOCI securities, unrealized gains/losses show up on the BS line item and AOCI in CSE, but don’t show up at all on the IS or CFS.

For HTM or Amortized Cost, the treatment most commonly used for debt securities, the unrealized gains and losses don’t appear anywhere.

How are the LIFO, FIFO, and Moving Average Weighted Cost methods for Inventory and COGS different?

The difference in the methods come down to timing.

For LIFO, last-in-first-out, you calculate COGS based on the cost of the inventory most recently acquired.

For FIFO, first-in-first-out, you calculate COGS based on the cost of the inventory first acquired.

For Average Weighted Cost, you calculate COGS based on the average cost of all the inventory has been acquired in a period.

But, under IFRS, LIFO is not allowed.

If inventory costs are rising, FIFO produces higher NI but lower cash flow because of taxes, while LIFO does the opposite.

For a Defined-Benefit Pension plan, how do the Pension Asset and Pension Liability change over time?

The Pension Asset changes based on the return the company earns (the Actual Return), how much the company contributes (Employer Contributions), and how much it pays out to employees (Benefit Payments).

There may also be "Other Adjustments" and plan contributions from employees.

The Pension Liability, or Pension Benefit Obligation, changes based on the Service Cost (the additional amount the company owes based on employees working longer or earning more), the Interest Cost (the PV of the Liability increasing due to the passage of time), the Experience (Gain) / Loss (actuarial estimates changing), and Benefit Payments.

Again, there may also be "Other Adjustments" and plan contributions from employees.

Why does the Pension Expense on the Income Statement consist of mostly non-cash expenses?

The main components of the Pension Expense on the Income Statement are the Service Cost, the Interest Cost, the Expected Return on Plan Assets, the Amortization of Net Losses, Gains, and Prior Service Costs, and "Other Adjustments."

(Under IFRS, the Amortization of Net Losses and Gains does not appear, but the other items do.)

The logic behind these items is that the company attempts to "smooth out" its gains and losses over time because the returns on Pension Assets are often volatile, so it uses various Amortization line items to do that.

None of these items represent upfront cash expenses – they represent hypothetical returns, the passage of time, or the amortization of Expected vs. Actual returns.

Even the Service Cost, which qualifies as "operational," is not a cash expense – it's the accrual of future expenses because of salary increases or employees working additional years.

On the Cash Flow Statement, most companies add back all, or a significant portion, of this Income Statement expense and then show a cash outflow for the Employer Contributions into the plan

Explain the links between the Pension Expense on the Income Statement, the Pension Plan Asset, the Pension Plan Liability, and the Pension items on the Cash Flow Statement.

Most, or all, of the Pension Expense on the Income Statement is added back on the Cash Flow Statement, and the company records its Employer Contributions as a cash outflow there.

Also, there's a Deferred Tax impact, depending on which items are Cash-Tax Deductible (e.g., just the Service Cost, the entire IS Pension Expense, just the Employer Contributions, etc.).

Of these line items, only the Employer Contributions from the CFS directly affect the Pension Asset; it also changes based on Actual Returns (i.e., Unrealized Gains/Losses) and Benefit Payments.

With the Pension Liability, the Service Cost and Interest Cost flow in from the Income Statement and increase it. Actuarial Gains and Benefit Payments also affect it (neither one is shown on the IS or CFS).

Finally, under U.S. GAAP, the Amortization of Expected vs. Actual Returns appears on the Income Statement and is influenced by the Actual Returns that flow into the Pension Asset.

Under IFRS, the difference between Expected and Actual Returns each year goes into AOCI within Equity on the Balance Sheet.

Walk me through the financial statements when there's a $100 Face Value Debt issuance with $5 in Issuance Fees, amortized over 5 years, but the Debt is repaid early – at the end of Year 3.

Assume a 5% coupon rate and no principal repayments until maturity, and explain just the changes in Year 3.

Originally, the debt is issued at a book value of $95 because of the issuance fees, it then amortizes towards par over the five year.

IS - there is a $5 interest expense, a $2 loss on extinguishment, and a $1 issuance fee amortization. This reduces pre-tax income by $8. Assuming a 25% tax rate, net income is down by $6.

CFS - NI starts down by $6. Add back the $2 non-cash loss and $1 issuance fee amortization. CFO is down by $3. Under CFF, record $100 cash outflow from repurchasing the bond. Overall, cash is down by $103

BS - On the assets side, cash is down by $103. On the L&E side, liabilities are down by $97 from the extinguishment of the debt, and equity is down by $6 from the loss in net income. Overall, both sides balance down by $103.

Walk me through the financial statements when there's a $100 Face Value Convertible Bond issued with a Liability Component of $80 and $5 in Issuance Fees.

Assume straight-line amortization over 5 years and a coupon rate of 1.0%.

To start, the book value of the debt is the Liability Component minus issuance fees ($75), so, the equity is $20. The L&E side is up by $95.

Cash is also up $95 on the assets side.

Going forward, the company records an interest expense of $1 and an Amortization of Financing Fees of $1 as well. Lastly, they also record a $4 ($20 equity discount / 5) for the amortization of the Debt Discount. These are all lumped into the interest expense, so pre-tax income is reduced by $6 each year.

At a 25% tax rate, that means that NI is down by $4.5 each year going forward.

On the CFS, you start down $4.5 from NI, before adding back the Amortization of the Financing Fees ($1) and the Debt Discount ($4) since these are both non-cash. Meaning, your cash balance is up by $0.05.

On the BS Assets side, you cash is up by $0.05. On the L&E side, the book value of debt goes up by $5 from the amortization. But, Net Income is CSE drags it down by $4.5. So, your net change on both sides balances up by $0.5.

There's a $100 Face Value Convertible Bond issued with a Liability Component of $80 and $5 in Issuance Fees.

Assume straight-line amortization over 5 years and a coupon rate of 1.0%

What happens if this same Convertible Bond converts into common shares at the end of Year 3?

The first step is to record a Loss on Debt Extinguishment to recognize a write-down in accordance with the unamortized issuance fees. Then, you also have the typical periodic cash interest expense and Amortization line items considered on the IS as well.

On the CFS, NI will be down, and you reverse the loss and amortization line items. Converting the bond to shares doesn’t have a cash consequence, so that is all you do on the CFS.

On the BS, both the debt and equity elements of the Convertible Bond get moved into CSE.

At the end of Year 3, the $20 Equity Component is the same, and the Liability Component equals the Face Value of $100 minus the remaining unamortized Debt Discount and the remaining unamortized Financing Fees, which means $100 – $8 – $2 = $90.

So, Common Shareholders' Equity increases by $110, the Equity Component decreases by $20, and the Liability Component decreases by $90.

Walk me through the financial statements over a year when a company has issued a $100 Face Value bond with 5% Cash Interest and 5% PIK Interest. Ignore the Issuance Fees.

PIK interest accrues to principal, so it does not actual represent cash going out the door. Considering that:

IS - Record interest expense of $5 and PIK interest expense of $5. Pre-tax income is down by $10. Assuming a 25% tax rate, NI is down by $7.5.

CFS - NI starts down by $7.5. Then, you add back the $5 of PIK interest since it is non-cash. Your ending balance of cash is down by $2.5

BS - On the assets side, cash is down by $2.5. On the L&E side, liabilities are up by $5 from the PIK interest accruing to the bond’s principal, under equity though NI is down by $7.5, so both sides balance down by $2.5.

Walk me through the statements when a Parent Co. already owns a 30% stake in Sub Co., and the Sub Co. earns $100 in Net Income and issues $40 in Dividends.

In this situation, you use the equity method of investing. So, starting on the IS,

IS - record a line item to increase NI by $30. NI is up by $30.

CFS - reverse the non-cash increase to NI of $30, you don’t actually get this income as cash. Then, record an inflow of $12 from the dividend payment you get for you 30% stake in the subco. So, your ending cash balance is up by $12.

BS - On the assets side, cash is up by $12, also investments are up by $18 from the difference between your attributable NI and dividend. On the L&E side, equity is up by $30 from the NI gain. Both sides balance up $30

Walk me through the Balance Sheet combination when Parent Co. goes from a 30% stake to an 80% stake in Sub Co., using 100% Cash for the purchase price.

Assume that Sub Co.'s Market Cap is $200 and that it has $200 in Total Assets and $50 in Total Liabilities. Also, assume that Parent Co. acquired its 30% stake in Sub Co. when Sub Co.’s Market Cap was $50, and that its Balance Sheet value has not changed since then

Start by valuing how much the purchase price provides a premium or discount to the existing ownership. Here, we do $200 × 30% - $50 × 30% = $45. So, the existing investment is worth $45 more than when it was originally made.

Goodwill is then created based on purchasing all of Sub Co’s minus their CSE ($150). So, at a $200 purchase price, we need $200 of goodwill.

On the Assets side of the BS, you need to deduct the (80%-30%) * $200 = $100 in cash used to make the acquisition. This also removes the original $15 in equity investments. Then, you add the $50 of new Goodwill with the Sub Co’s assets valued at $200, so assets are up $135.

On the L&E side, Parent Co adds Sub Co’s $50 of liabilities and creates a $40 NCI for the 20% of the subco that it doesn’t own ($200 × 20% = $40). On top of that, they record the $45 premium to the book value of the previous equity investment within CSE.

So, L&E is up by $135, balancing both sides.

Now, walk me through what happens in Year 1 following the deal when Parent Co. maintains its 80% stake in Sub Co. Assume that Parent Co.'s Net Income is $100, with $20 of Dividends, and that Sub Co.'s Net Income is $20, with $5 of Dividends.

If Parent Co has $100 of NI, and Sub Co has $20, then there is a combined NI of $120. But, at the bottom of the income statement, the Parent Co has to deduct the 20% of the Sub Co’s NI that they do not have, which is 20% * $20 = $4.

So, NI to the Parent is up by $116.

CFS - NI begins up by $116, but then the deduction of $4 gets reversed because it is non-cash, the parent is the only one with an actual claim to the cash. Then, it records 80% * $5 = $4 of Dividends received from SubCo. In CFF, the Parent deducts its $20 of dividends and the subco’s entire $5 of dividends. Therefore, cash at the bottom is up by $99.

BS - on the assets side, cash is up by $99. On the L&E side, NCI increases by Net Income to Noncontrolling Interest ($4), increases by Dividends received from Sub Co ($4), and decreases by Sub Co’s total dividends ($5), so it is up by $3 so far.

CSE increases by the $116 NI to Parent, and decreases by the $20 of dividends issued, so it is up by $96.

Therefore, both sides balance up by $99.

At a high level (no numbers), explain what happens if Parent Co. sells its entire 80% stake in Sub Co. after a few years

The Parent Co will have to deconsolidate the financial statements, including goodwill, A & L, and NCI.

Also associated with a sale for the Parent Co would be a Gain or Loss within CSE and the cash received from the sale into Assets.

That gain or loss is based on the (Market Value of Stake Sold + Market Value of New Equity Investment + Book Value of Noncontrolling Interests) - Sub Co’s Net Assets including goodwill. This gain or loss is then taxes, with the cash proceeds equaling the Cost Basis Recovered plus the After-Tax Gain or Loss.

Walk me through the statements under U.S. GAAP when employees receive $40 of Stock Based Compensation and then exercise their options and receive shares once the SBC’s value has increased to $140 in a future year

When the SBC first got issued, the $40 wasn’t Cash-Tax deductible, meaning a DTA of $10 was created (assuming a 25% tax rate)

Once the SBC value increased and gets exercised, the difference ($140-$40 = $100) creates an excess tax benefit of $100 × 25% = $25. This reduces Income Taxes and increases NI by $25.

CFS - NI starts up by $25, reverse the DTA ($10 cash inflow), so cash is up by $35.

BS - On the assets side, cash is up by $35, DTA is down by $10, net change is up $25. On the L&E side, NI is up $25, which increases equity. So, both sides are up by $25.

Walk me through the statements when a company has $100 of Equity Securities classified as Trading or FVPL, and it records an Unrealized Gain of $40 on them.

The unrealized gain shows up on the Income statement below operating income, and increases pre-tax income by $40. At a 25% tax rate, NI is up by $30.

CFS - NI starts up $30, but then you need to reverse the gain since it is non-cash (-$40) but your DTL also increases, which is a $10 cash “inflow” since you don’t pay cash taxes on unrealized gains or losses. So, net you cash does no change.

BS - On the assets side, cash is unchanged. Equity securities are up by $40. On the L&E side, the DTL is up by $10, and NI increases CSE by $30. So, both sides balance up by $40.

A company records $40 in Pension Service Costs and $40 in Pension Interest/Finance Costs, as well as $100 in Employer Contributions into the plan.

Assume that the Income Statement expenses are NOT Cash-Tax Deductible, but that the Employer Contributions are, and walk through the financial statements.

On the Income Statement, Pre-Tax Income is down by $80, so Net Income is down by $60 at a 25% tax rate.

On the Cash Flow Statement, Net Income is down by $60, but you add back the entire $80 Pension Expense from the Income Statement.

This $80 Pension Expense is not Cash-Tax Deductible, but the $100 Employer Contributions are, so the company's Cash Taxes are lower than its Book Taxes by ($100 – $80) * 25% = $5.

This is shown as a positive $5 in Deferred Taxes, and the $100 in Employer Contributions are negative, so Cash is down by $75, since –$60 + $80 + $5 – $100 = –$75.

On the Balance Sheet, Cash is down by $75, the Pension Assets are up by $100 from the Employer Contributions, and the Deferred Tax Asset is down by $5, so Total Assets are up by $20.

On the L&E side, the Pension Liability is up by $80 because of the Pension Expense added back on the CFS, and Common Shareholders' Equity is down by $60 due to the reduced Net Income.

So, both sides are up by $20 and balance.

What determines the Market Value of Debt?

The PV of the future cash flows of the debt (consisting of interest payments + principal repayment) discounted at the yield to maturity (YTM) on similar debt in the market.

If prevailing market yields on similar debt fall, does the Market Value of an existing bond rise or fall — and why?

The market value of existing bonds will increase, because the discount rate becomes smaller.

Since the new interest rates are lower, debt yielding higher coupons will be considered more valuable, so the price goes up.

Is the "Debt" figure on the Balance Sheet the amount the company pays interest on?**

No, because the Balance Sheet shows the book value of debt. A company pays interest on the Face Value of the debt it has issued.

The difference consists of unamortized debt discounts/premiums, PIK interest, and issuance fees

How are debt issuance fees recorded?

They are recorded as a detractor from the book value of the bond. The company has to pay then in cash upfront, but then it is amortized into an interest expense to allocate that cash outflow over the life on the bond. This is a non-cash charge, though, so it gets reduced on the BS.

What is an Original Issue Premium and how does its accounting differ from OID?

An OIP occurs when, between the time the terms of the bond were decided as far as coupon, and the time it gets issued into the market, interest rates in the market have decreased. This means that creditors are willing to pay more for the higher rate of the new bond issuance, and the company can issue at a premium to face value.

The accounting isn’t really different, you still have to amortize the difference. But, in this case, the amortization produces “negative interest”, and if you extinguish the debt early, you recognize a gain, not a loss.

Where do the OID and issuance fees show up on the Cash Flow Statement when debt is first issued?**

They show up as outflows in CFF since they reduce the amount the company receives in cash from the issuance.

Are the OID/issuance-fee amortization and losses on debt extinguishment cash-tax deductible?**

It isn’t very straightforward, and it depends on the region to some extent. However, these fees and losses are typically very minor, so we often choose to ignore the tax implications of Book v. Cash