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.

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 "managing" income by choosing to recognize gains or losses. Gains or losses on early debt redemption are classified as extraordinary items.

Troubled Debt Restructurings (covered in chapter 7, pages 347-354)
When a firm cannot meet the interest and/or principal payments on its debt, it may restructure the debt. This can involve settling the debt immediately for less than its book value, or continuing with modified terms, such as a reduction in future interest and/or principal payments. By definition, the borrower will pay less than originally contracted for; thus, the borrower will always have a gain on restructuring. Analogously, since the lender will receive less, the lender will always have a loss. The key issues are when should the gain/loss be recognized, and for how much. There are 3 types of restructurings: (1) settlement, (2) impairment, and (3) restructuring.

Settlement - When troubled debt is settled, the lender gives the borrower another asset (perhaps cash) in exchange for extinguishing the debt. The value of the asset, by definition, is less than the value of the debt (otherwise the borrower could sell the asset and pay off the debt in full). The difference is the borrower's gain and the lender's loss (which are equal). Both parties recognize the loss/gain at the time of settlement. Note that the borrower can recognize a gain or loss on disposition of the asset, which is the difference between its book value versus its market value. Assume that a note is settled in exchange for PPE. The journal entries are:
lender DR CR
Asset (FMV)
Loss on debt retirement(plug)
N/R (NBV)

borrower DR CR
N/P (NBV)
Asset (NBV)
Gain on debt retirement
Loss Or Gain on asset transfer
Note that the lender's loss equals the borrower's gain on debt retirement.

Impairment - In impairment, the debt contract lives on, but with a lower future cash payment than originally contracted for. Impairment is a specific type of restructuring when there is no recontracting, but the lender knows that the loan has been impaired (i.e., the original contracted cash flows will not be paid back in full). Due to accounting conservatism, the lender recognizes a loss immediately upon impairment, whereas the borrower defers recognition of the gain until the (lower) final payment is made.
The lender calculates the loss as the difference between (1) the BV of the note at the time of impairment versus (2) the new lower expected final payment discounted at the note's effective rate of interest (r%). By definition, the BV equals the original final payment discounted at the note's effective rate of interest. Thus, the loss is the decrease in the payment discounted at the effective interest rate (i.e., the lender writes down the note to the new, lower BV). From this point on, the lender calculates periodic interest revenue in the usual way: r% x BV of the note, using the note's new, written down, BV.

For the borrower, the gain is the difference between the original versus the new final payments, and is recognized when the final payment is made. The example below shows the journal entries for both parties.

Restructuring - Restructuring is similar to impairment, but where there is a specific recontracting. In this way, there is immediate, objective evidence of the decline in debt value. The lender calculates the loss in the same way as for an impairment: the BV of the loan (which equals the original payments discounted at r%) versus the new, lower payments discounted at r%, and he writes down the loan to this new value immediately. Also like impairment, the lender continues to calculate interest revenue = r% x new BV.

Unlike an impairment, however, the borrower might recognize a gain at the time of impairment. The borrower compares the new, lower undiscounted cash flows to the NBV of the loan (which equals the discounted original cash flows). [Note: by not discounting, the calculated value will be higher than with discounting; however, the cash flows are lower. These 2 forces work in opposite directions, and the new undiscounted value can be higher or lower than the original value.]

If the new undiscounted amount is lower, a gain is recognized immediately. The gain is the difference between the 2 values. If a gain is recognized, the loan is written down to the undiscounted value of the cash flows (DR to the liability and CR to the gain). Effectively, since there is no discounting, the implicit interest rate is zero; thus, all future cash payments are repayments of principal, and the borrower recognizes no more interest expense.

If the new undiscounted amount is not lower, no gain is recognized. The borrower calculates the implicit interest rate (the internal rate of return) that equates the future cash flows with the (unchanged) BV of the loan. Since the cash flows are lower, this new interest rate must be lower than the original effective interest rate of the loan. The borrower then uses this new interest rate to calculate future interest expense = new r% x BV of the loan. Since the new r% is lower, future interest expense is lower (than previously), and net income is higher. In this way, the gain is deferred over the remaining life of the loan, rather than recognized up front, consistent with accounting conservatism. The example below shows the journal entries for both parties.

Note the following central principles of both impairments and restructurings: (1) the lender uses the original interest rate, both to calculate the loan loss and to compute interest revenue for the rest of the note's life, and (2) consistent with accounting conservatism, the lender always recognizes a loss immediately, whereas the borrower usually delays recognition of the gain - the only exception for the borrower is when his payments are reduced so much, that even when not discounted, they are of lower value than the original discounted payments.

The difference between impairment vs restructuring can be subtle. In general, a restructuring requires a formal recontracting, whereas an impairment does not. To compare the two types of events, consider the following examples.

Example 1: Impaired/Restructured Loan, with restructuring borrower gain up front
Assume a r=10%, 5 year, zero coupon note, with a $1,000 principal. Assume that with 2 years remaining, the borrower and the lender agree that the final principal repayment will be $700 instead of the original $1,000. At this point the NBV of the original (unimpaired) loan is $1,000/(1.10)2 = $826 (rounded to the nearest $). It is a N/R (N/P) for the lender (borrower). The PV of the impaired note is $700/(1.10)2 = 578. For the borrower under restructuring, the key point here is that the original NBV 826 is greater than the undiscounted new cash flows, 700.

Under both impairment and restructuring, the lender writes down the N/R to $578 at this time, by taking a loss of 826-578=248:
DR CR
Loss 248
N/R 248
He then goes forward with the N/R at the new NBV of $578. His final 2 period's je's are:
DR CR
per 4: N/R 58
Interest revenue 58 Note: 58=10% x 578; new NBVof N/R =578+58=636

per 5: N/R 64
Interest revenue 64 Note: 64=10% x 636; new NBVof N/R =636+64=700

final: Cash 700
N/R 700

Under impairment, the borrower ignores the change in NBV and continues to account for the $1,000 N/P, such that the gain is recognized at the end:
DR CR
per 4: Interest expense 83
N/P 83 Note: 83=10% x 826; new NBVof N/P =826+83=909

per 5: Interest expense 91
N/P 91 Note: 91=10% x 909; new NBVof N/P =909+91=1000
final: N/P 1000
Cash 700
Gain 300
Under restructuring when the NBV of the original loan > undiscounted cash flows of the new loan, the borrower recognizes a gain immediately for the difference, thereby wriring the loan down to its undiscounted value. Since the effective interest rate is zero, there is no future interest expense, and all future cash flows are repayments of the loan:
DR CR
N/P 126
Gain 126 Note: 126=826(original discounted NBV)-700(new undiscounted NBV)

[note: per 4 and per 5: no je's, since no cash payments in this example]
DR CR
final: N/P 700
Cash 700

Note that under impairment, the net 2 year effect on the borrower's I/S is:
83 DR (per 4) + 91 DR (per 5) + 300CR (final) = 126 CR. Under restructuring, the effect on the borrower's I/S is 126 CR (per 3). Thus, the net effect on the borrower's I/S is the same, only the timing differs.

Example 2: Impaired/Restructured Loan, with no restructuring borrower gain up front
Assume an r=10%, 5 year, zero coupon note, with a $1,000 principal. Assume that with 2 years remaining, the borrower and the lender agree that the final principal repayment will be $900 instead of the original $1,000. At this point the NBV of the original (unimpaired) loan is $1,000/(1.10)2 = $826 (rounded to the nearest $). It is a N/R (N/P) for the lender (borrower). The PV of the impaired note is $900/(1.10)2 = 744. For the borrower under restructuring, the key point here is that the original NBV 826 is less than the undiscounted new cash flows, 900.

Under both impairment and restructuring, the lender writes down the N/R to $744 at this time, by taking a loss of 826-744=82
DR CR
Loss 82
N/R 82
He then goes forward with the N/R at the new NBV of $744. His final 2 period's je's are:
DR CR
per 4: N/R 74
Interest revenue 74 Note: 74=10% x 744; new NBVof N/R =744+74=818

per 5: N/R 82
Interest revenue 82 Note: 82=10% x 818; new NBVof N/R =818+82=900

final: Cash 900
N/R 900

Under impairment, the borrower ignores the change in NBV and continues to account for the $1,000 N/P, such that the gain is recognized at the end:
DR CR
per 4: Interest expense 83
N/P 83 Note: 83=10% x 826; new NBVof N/P =826+83=909

per 5: Interest expense 91
N/P 91 Note: 91=10% x 909; new NBVof N/P =909+91=1000

final: N/P 1000
Cash 900
Gain 100
Note that only the borrower's final je differs from the previous example, because in both cases the borrower ignores the "gain" until the end.

Under restructuring, the NBV of the original loan < undiscounted cash flows of the new loan, so the borrower does not recognize a gain immediately, but computes the implicit IRR that equates the original NBV with the new final cash flows:$900/(1+r)2 = $826, for r= 4.38%. The borrower then uses this IRR% to compute his interest expense going forward, deferring his gain until the end. Note that since the cash payment has been reduced, the new IRR% must be lower than the original effective r% on the loan. Thus, using the new IRR% results in lower interest expense.
per 4: DR CR
Interest expense 36
N/P 36 Note: 36=826x4.38%; new NBV=826+36=862

per 5: DR CR
Interest expense 38
N/P 38 Note: 38=862x4.38%; new NBV=862+38=900

DR CR
final: N/P900
Cash 900

Note that under impairment, the net 2 year effect on the borrower's I/S is:
83 DR (per 4) + 91 DR (per 5) + 100 CR (final) = 74 DR. Under restructuring, the effect on the borrower's I/S is 36 DR (per 4) + 38 DR (per 5) = 74 DR. Thus, the net effect on the borrower's I/S is the same, only the timing differs.

Contingent Liabilities
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.