Advanced Accounting Flashcards
What is a Convertible Bond?
In addition to “standard” Debt, such as bonds that companies issue to investors and promise to
pay interest on, companies can also issue Convertible Bonds that may be “converted” into
Common Shares if the company’s Share Price exceeds a certain level (the “Conversion Price”).
In exchange for this conversion option, investors accept lower coupon rates. So, a company might be able to pay 0.5% or 1.0% on a Convertible Bond if it would normally pay 4.0% or 5.0% on a traditional bond.
Convertible Bonds save companies money upfront by reducing their cash interest expense, but they can “cost” more if they convert into Equity later on.
Why might a company issued Debt with an Original Issue Discount (OID), and how is it recorded on the statements?
A company would issue Debt with an Original Issue Discount if the Market Value of the Debt, upon initial issuance, is different from its Face Value.
For example, yields on similar bonds in the market are 5%, but this company is offering only 4%, so it issues the Debt at a discount to incentivize investors to buy the issuance.
The OID means that investors can buy the bond for less than its Face Value, so they might be able to buy it for $95 if the Face Value is $100 (for example).
This discount is deducted from the Book Value of Debt on the Balance Sheet, and it amortizes over time so that the Book Value increases each year until maturity. Upon maturity, Book Value = Face Value.
Explain consolidation accounting.
Consolidation accounting is used when one company owns >= 50%, but less than 100%, of another company.
In this scenario, the financial statements of both companies are consolidated 100%, i.e., all the items from Parent Co and Sub Co are added together.
Parent Co then makes adjustments for Sub Co’s Net Income and Dividends.
On the Income Statement, it subtracts (1 – Ownership Percentage) * Sub Co.’s Net Income (“Net Income Attributable to Noncontrolling Interests”), and on the Cash Flow Statement, it reverses this.
Then, it also records a positive cash inflow for Ownership Percentage * Sub Co.’s Dividends.
Further down on the Cash Flow Statement, it records deductions for 100% of the Dividends from both Parent Co and Sub Co.
On the Balance Sheet, Net Income Attributable to Noncontrolling Interests (the reversal of the
deduction on the IS), 100% of Sub Co.’s Dividends, and Ownership Percentage * Sub Co.’s Dividends all flow into the Noncontrolling Interests (NCI) line item within Equity.
The net effect is that the NCI increases by the Net Income that’s attributable to other shareholders, and it decreases by the Dividends that go to other shareholders.
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.
Parent Co. records 30% * $100 = $30 in Equity Investment Earnings on its Income Statement, which boosts its Net Income by $30.
On the CFS, Net Income is up by $30, but then Parent Co. reverses these Equity Investment Earnings and records $40 * 30% = $12 in Dividends Received from Equity Investments.
At the bottom, Cash is up by $12.
On the Balance Sheet, Cash is up by $12 on the Assets side. The Equity Investments line item is up by $30 from the Equity Investment Earnings and down by $12 from the Dividends, so the Assets side is up by $30.
The L&E side is also up by $30 because CSE is up by $30 due to the Net Income increase, so both sides are up by $30 and balance.
At a high level (no numbers), explain what happens if Parent Co. sells its entire 80% stake in Sub Co. after a few years.
Parent Co. has to deconsolidate the financial statements by removing all of Sub Co.’s Assets and Liabilities, the new Goodwill that was created in the deal to acquire the 80% stake, and the Noncontrolling Interests.
Also, Parent Co. has to record the Gain or Loss on the sale within Common Shareholders’ Equity
and the total Cash it receives on the Assets side.
The Gain or Loss is based on (Market Value of Stake Sold + Market Value of New Equity Investment, If Any + Book Value of Noncontrolling Interests) – Sub Co.’s Net Assets Including Goodwill.
This Gain or Loss is taxed, and the total Cash proceeds equal the Cost Basis Recovered plus the After-Tax Gain or Loss.
What is PIK interest? (aka Accrued Interest)
Interest accrues to the principal
Increases both the Face Value and the Book Value of Debt
Explain Equity Method of Accounting.
The main idea of the equity method is that Parent Co. records its Ownership Percentage * Sub
Co.’s Net Income on its Income Statement under “Equity Investment Earnings,” or a similar
name, but nothing else from Sub Co. – all the items above are only the Parent’s.
Then, Parent Co. reverses that line item on its Cash Flow Statement and also records Ownership Percentage * Sub Co.’s Dividends as a positive on its CFS.
Both these Cash Flow Statement line items then link into Equity Investments on the Assets side of the Balance Sheet.
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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.
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.
Initially, Cash on the Assets side increases by $100, and Debt on the L&E side also increases by $100.
In Year 1, the company records $100 * 10% = $10 of Interest Expense on the Income Statement, so its Pre-Tax Income falls by $10, and its Net Income falls by $7.5 at a 25% tax rate.
On the CFS, Net Income is down by $7.5, but you add back the $5 of PIK Interest, which is non-cash, so Cash at the bottom is down by $2.5.
On the BS, Cash is down by $2.5, so the Assets side is down by $2.5. On the L&E side, Debt is up by $5 from the PIK interest, and CSE is down by $7.5 due to the reduced Net Income, so both sides are down by $2.5 and balance.
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.
Parent Co. records 30% * $100 = $30 in Equity Investment Earnings on its Income Statement, which boosts its Net Income by $30.
On the CFS, Net Income is up by $30, but then Parent Co. reverses these Equity Investment Earnings and records $40 * 30% = $12 in Dividends Received from Equity Investments. At the bottom, Cash is up by $12.
On the Balance Sheet, Cash is up by $12 on the Assets side. The Equity Investments line item is up by $30 from the Equity Investment Earnings and down by $12 from the Dividends, so the Assets side is up by $30.
The L&E side is also up by $30 because CSE is up by $30 due to the Net Income increase, so both sides are up by $30 and balance.
