AC210

FINANCIAL STATEMENT ANALYSIS FOR INVESTMENT

BANKING AND ASSET MANAGEMENT

Dr. Maria Correia

Summer School 2023

 Investment Banking

Debt Capital How can accounting information be

Equity Capital used in asset allocation and, more
M&A broadly, in making decisions about
providing equity and debt financing to
Asset Management firms?

Equities
How are these transactions then
Corporate Bonds
reflected in firms’ financial statements?
Other fixed income
Commodities
Property
 A Taste of My Research

Role of Accounting Information in Credit Markets

 A Taste of My Research

Market Accounting
information information

Estimates of default
probability

Theoretical credit
spreads (CS*)

BUY if CS>CS*
SELL if CS<CS*

“We compare existing accounting-based and market-based models to forecast default. We then
assess whether the credit market completely incorporates this default information into credit spreads.
We find that credit spreads reflect information about forecasted default rates with a significant
lag. This unique evidence suggests a role for value investing in credit markets.”
 AC210

1. Introduction
2. Cash-flow Analysis
3. Discounted Pay-offs Valuation
PART I
4. Accrual Accounting: Revenue and Expense Recognition
5. Valuation Using Multiples: P/E and P/B and Residual Income Valuation
6. Fundamental Analysis: Quality/Value Investing

1. Debt Financing (I): Accounting for Financial Debt

2. Debt Financing (II): Leases and Pensions
3. Equity Financing (I): Accounting for Equity Transactions and Convertible Debt
PART II
4. Equity Financing (II): IPOs and Earnings Management
5. Mergers and Acquisitions: Consolidated Statements, Minority Interest, and the Rise of
Intangibles
6. Capital Market Disclosures: Street vs. GAAP Earnings Metrics and ESG Disclosures
Session 7
DEBT FINANCING I: ACCOUNTING FOR FINANCIAL
DEBT
Dr. Maria Correia

Summer School 2023

 Agenda

 Accounting for financial debt:

 Loans
 Bonds
 Bonds issued at par

 Bonds issued at premium-discount

 Interpreting firms' financial debt disclosures

 Analysing firms' financial commitments

 Financial liabilities
 Firms can finance their operations by raising debt or equity (or an hybrid)
 Debt financing can have multiple advantages:
 Preserve ownership and control of the company

 Tax deductible interest payments

 …and multiple disadvantages:
 Need to pay back principal and interest at given times

 Increased bankruptcy risk (and decreased credit ratings)

 Restrictions to investment, dividends, firms’ operations (covenants)

 Firms have different options to raise debt financing including:
 Bank loans (including lines of credit)

 Bonds

 Others (e.g., non-bank lending, government-backed loans, leases, etc.)

In the next two sessions we will focus on debt… we will then move to equity
 Financial liabilities

 Liability (IASB Conceptual Framework): a present obligation of the entity to transfer

an economic resource as a result of past events
 If the issuer can be required to settle the obligation in cash or another financial
asset, then the liability is classified as a financial liability

 Conceptually, financial liabilities should be shown in the financial statements as the

present value of the future cash outflows required to satisfy the obligation
 This allows firms to record interest expenses as incurred

 Almost all financial liabilities are measured at amortised cost

 Interest expenses are recorded in P&L based on the effective interest rate (e.g.,
for bonds, the effective interest rate is the bond's yield at the issue date)
 Financial liabilities

 Exception: financial liabilities held for trading are measured at FVTPL

 These could include financial liabilities that are incurred with an intention to
repurchase them in the near term (e.g., a quoted debt instrument that the issuer
may buy back in the very near future)
 Fair value movements related to the credit risk of the firm can be recorded in
other comprehensive income (OCI)
 When the default risk of a company increases, the fair value of liabilities decreases –
gain
 When the default risk of a company decreases , the fair value of liabilities increases –
loss
 The treatment of FVTPL financial liabilities is similar under IFRS and US GAAP
with an exception: under US GAAP, amounts recorded in OCI are moved to P&L
over the life of the liability (i.e., they are "recycled"); under IFRS, these amounts
are never recycled (not even when the liability is settled!)
 A simple example- a traditional loan

A company obtains a 3-year loan in the amount of £1000. Interest is payable annually at
a 10% rate.

Assets Liabilities Shareholders’ Equity

Cash Loans P&L
Year 0 1,000 1,000
Year 1 (100) (100)
Year 2 (100) (100)
Year 3 (1,100) (1,000) (100)

Why do we only record a liability for 1,000 in year 0 if we already know

that we are going to have to pay to the bank 1,300?
 What is a bond?

 A bond is a debt security, in which the issuer owes the holders a debt and is obliged
to repay the principal and interest (the coupon) at a later date. Bonds are generally
issued for a fixed term longer than a year and may be sold to the investing public

 Although a bond is just a loan (but in the form of a security), the terminology used is
rather different:
 Issuer is equivalent to the borrower
 Bondholder is equivalent to the lender
 Coupon is equivalent to the stated interest
 The only periodic payments in a bond are the interest (coupon) payments- the
principal (amount borrowed) is repaid in a lumpsum at the maturity of the loan
 Bonds can be redeemed before expiration
 Types of bonds

 Secured bond – specific assets are pledged as a guarantee of repayment at maturity

 Unsecured bond (or debenture) – no assets are pledged as a guarantee of
repayment at maturity

 Callable bond – contains a call feature that gives the issuer the option of retiring the
bonds before maturity
 Convertible bond – contains a conversion feature that allows the bonds to be
converted into shares of the issuer’s common stock

Why do companies issue convertible bonds?

 Terminology

On the face of the bond

 Face value (principal): amount to be paid at maturity
 Coupon rate (r): rate used to compute the cash payments each period (usually semi-
annually)
 Maturity date/ Term: date on which principal will be repaid

In the market (the bond market)

 Price: actual cash received
 Market rate or yield: the rate or return earned on the original price
 Bond issuance process

 Bond indenture and bond prospectus – specify all the details of the bond offering
(maturity date, interest rate, date of each interest payment, whether bonds are
callable or convertible, etc.)
 Covenants – legally binding agreements between issuer and bondholder designed to
protect bondholders
 Bond certificate – the document that investors receive when they purchase bond
securities
 Trustee – an independent party appointed to represent bondholders and to
determine whether the issuer fulfils the provisions of the bond contract

Note: the terms “bonds” and “notes” are often used interchangeably. Sometimes the
term notes is used for debt securities with shorter maturities, which are issued more
frequently, whereas the term bonds is reserved for a discrete large offering with longer
maturity
Example – Amazon notes prospectus
Example – Amazon notes prospectus
Example – Amazon notes prospectus
Example – Amazon notes prospectus
Example – Amazon notes prospectus
 Bond pricing

 Bonds are usually intended to be issued for exactly the amount of principal but
changing market forces can cause the bond to rise or fall in value in the short interval
after the coupon is set and the bond goes to the market

 ↑ Demand → Bond is sold at premium, i.e., the market requires a lower interest
(market or effective interest) than the interest rate specified in the bond (coupon
rate)
 ↓ Demand → Bond is sold at discount, i.e., the market requires a higher interest
(market or effective interest) than the interest rate specified in the bond (coupon
rate)

 A premium/discount changes the amount of cash that the bond issuer receives
 A toy example

Consider these three bonds, all with 10-year maturity, and a principal amount of £1,000

Premium Par Discount

Coupon Rate 12% 12% 12%
Market Rate 10% 12% 14%
Present Value £1,123 £1,000 £896

Bond prices are determined by the interest rate demanded by the

market (effective interest rate) relative to the interest rate offered by
the firm (coupon rate)
 Bond pricing

Relative to the face value of a bond, the bond price can be at:

Par Discount Premium

proceeds=principal proceeds<principal Proceeds>principal
coupon rate=market rate coupon rate<market rate coupon rate>market rate
 Bond pricing

The price of a bond is the sum of the present values of two different streams of cash
flows:
 Present value of the face (or principal) amount
 Present value of the annuity of coupon payments

Going back to the three 10-year maturity bonds, with a principal amount of £1,000 in our
example:

Premium Par Discount

Coupon Rate 12% 12% 12%
Market Rate 10% 12% 14%
Present Value (A) (B) (C)

How much would you be willing to buy each of these bonds for?
 Bond pricing

(A) 1000 × 12% × 1 −

1
1000 (1 + 10%)10
𝑃𝑃𝑃𝑃 = + = 1,123 Premium
(1 + 10%)10 10%
principal coupons

(B) 1000 × 12% × 1 −

1
1000 (1 + 12%)10
𝑃𝑃𝑃𝑃 = + = 1,000 Par
(1 + 12%)10 12%

(C) 1000 × 12% × 1 −

1
1000 (1 + 14%)10
𝑃𝑃𝑃𝑃 = + = 896 Discount
(1 + 14%)10 14%
 Accounting for financial liabilities

Long-term liabilities
Generally presented in the balance sheet at the present value of payments needed to
fulfil the obligation

Short-term liabilities
Generally not discounted because of the short period of time until they get resolved (the
short period of time would cause the amount of any discount to be small enough to be
considered immaterial)
Example - Kroeger

11,294
 Accounting for bonds

Two valuation approaches

 Historical (amortized) cost (the traditional approach) → fair value disclosed in notes
but not recognized on the balance sheet

 Mark-to-market → adjust to fair or market value at each reporting date (FVTPL)

 Example - Kroeger

Liabilities at
historical cost
on the
balance sheet

Fair value
disclosed in
the footnotes
 Accounting for bonds

At issuance

 Increase cash by bond price

 Increase “Bonds payable” by face value

 The difference between bond price and face should go to:

 Premium on bonds if positive (i.e., if the bond is issued at premium)
 Discount on bonds if negative (i.e., if the bond is issued at discount)
 Accounting for bonds- at issuance

Going back to our example:

Premium Par Discount

Coupon Rate 12% 12% 12%
Market Rate 10% 12% 14%
Present Value £1,123 £1,000 £896

A particular case
of a discount
bond is a zero
coupon bond.
Why?
 Accounting for bonds- at issuance

Going back to our example:

Assets Liabilities
Cash Bonds payable Premium on Discount on
bonds Bonds
If issued at par 1,000 1,000
If issued at premium 1,123 1000 123
If issued at discount 896 1000 (104)
 Accounting for bonds

After issuance

 Decrease P&L by interest expense (market yield at issuance times the net book value
of the bond)

 Decrease cash by interest paid (coupon rate multiplied by face value)

 Decrease “Premium” or “Discount” account by the difference between interest

expense and interest paid

Why do we do this?
 Accounting for bonds- after issuance

Bond issued at par

Coupon rate=market rate=12%

Assets Liabilities SE
Cash Bonds Premium on Discount P&L
payable bonds on Bonds
Issuance 1,000 1,000
At the end of the year (120) (120)
 Accounting for bonds- after issuance

Coupon rate 12%

Market rate 12%
Principal 1000

BB(Book value Interest Coupon EB (Book value

Year Payments PV (t=0) bond liability) Expense Payment bond liability) PV(t=k)
1 120 107.14 1,000 120 120 1,000 1,000
2 120 95.66 1,000 120 120 1,000 1,000
3 120 85.41 1,000 120 120 1,000 1,000
4 120 76.26 1,000 120 120 1,000 1,000
5 120 68.09 1,000 120 120 1,000 1,000
6 120 60.80 1,000 120 120 1,000 1,000
7 120 54.28 1,000 120 120 1,000 1,000
8 120 48.47 1,000 120 120 1,000 1,000
9 120 43.27 1,000 120 120 1,000 1,000
10 1120 360.61 1,000 120 120 1,000 1,000
NBV 1,000
Total interest=1,200
Total coupons=1,200
 Accounting for bonds- after issuance

Bond issued at discount

Coupon rate=12%; market rate=14%

Assets Liabilities SE
Cash Bonds Premium on Discount P&L
payable bonds on Bonds
Issuance 896 1,000 (104)
At the end of the year (120) 5 (125)
 Accounting for bonds- after issuance

Coupon rate 12%

Market rate 14%
Principal 1000

BB(Book value Interest Coupon Amortization Discount EB (Book value

Year Payments PV (t=0) bond liability) Expense Payment of discount balance bond liability) PV(t=k)
1 120 105.26 896 125 120 5 (99) 901 901
2 120 92.34 901 126 120 6 (93) 907 907
3 120 81.00 907 127 120 7 (86) 914 914
4 120 71.05 914 128 120 8 (78) 922 922
5 120 62.32 922 129 120 9 (69) 931 931
6 120 54.67 931 130 120 10 (58) 942 942
7 120 47.96 942 132 120 12 (46) 954 954
8 120 42.07 954 133 120 13 (33) 967 967
9 120 36.90 967 135 120 15 (18) 982 982
10 1120 302.11 982 138 120 18 0 1,000 1,000
NBV 896
Discount (104)
Total interest=1,304
Total interest=Total coupons+Discount
Total coupons=1,200
 Accounting for bonds- after issuance

Bond issued at premium

Coupon rate=12%; market rate=10%

Assets Liabilities SE
Cash Bonds Premium on Discount P&L
payable bonds on Bonds
Issuance 1,123 1,000 123
At the end of the year (120) (8) (112)
 Accounting for bonds- after issuance

Coupon rate 12%

Market rate 10%
Principal 1000

Payment BB(Book value Interest Coupon Amortization Premium EB (Book value

Year s PV (t=0) bond liability) Expense Payment of premium balance bond liability) PV(t=k)
1 120 109.09 1,123 112 120 (8) 115 1,115 1,115
2 120 99.17 1,115 112 120 (8) 107 1,107 1,107
3 120 90.16 1,107 111 120 (9) 97 1,097 1,097
4 120 81.96 1,097 110 120 (10) 87 1,087 1,087
5 120 74.51 1,087 109 120 (11) 76 1,076 1,076
6 120 67.74 1,076 108 120 (12) 63 1,063 1,063
7 120 61.58 1,063 106 120 (14) 50 1,050 1,050
8 120 55.98 1,050 105 120 (15) 35 1,035 1,035
9 120 50.89 1,035 103 120 (17) 18 1,018 1,018
10 1120 431.81 1,018 102 120 (18) 0 1,000 1,000
NBV 1,123
Premium 123
Total interest=1,077
Total interest=Total coupons-Premium
Total coupons=1,200
 Interest expenses

Interest expenses
140

135

130

125

120

115

110

105

100
1 2 3 4 5 6 7 8 9 10

Interest expense- par Interest expense- discount Interest expense- premium

 Bond liability

Bond liability
1,150

1,100

1,050

1,000

950

900

850

800
1 2 3 4 5 6 7 8 9 10

Liability- par Liability-discount Liability- premium

 Accounting for bonds – after issuance

What happens when market prices/ interest rates change?

 When bonds are accounted for at historical cost, changes in market prices and
interest rates are not reflected in the financial statements. Fair values are disclosed in
the notes
 When bonds are accounted for at fair value, their book value is updated at the end of
each year to reflect their fair value. Under IFRS:
 Changes due to “own credit risk” are recognized in OCI
 Other fair value changes are recognized in P&L
 When debt is repurchased prior to maturity, companies record a gain/loss in P&L
when the book value exceeds/ is less than the purchase price
Example – Amazon
Example – Volkswagen
Example – Volkswagen