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Unformatted text preview: © 2002 American Accounting Association
Vol. 16 No. 2
pp. 169–181 COMMENTARY Fair Valuing Debt Turns Deteriorating
Credit Quality into Positive Signals
for Boston Chicken
Robert C. Lipe
Robert C. Lipe is an Associate Professor at the University of Oklahoma.
SYNOPSIS: This article analyzes proposed accounting for financial instruments
using Boston Chicken’s financial report from 1997. The example shows how the
proposal would cause Boston Chicken to reduce the carrying value of debt and to
recognize a gain as its credit quality deteriorated. Several important financial ratios—debt-to-equity, return-on-equity, and interest-coverage—based on reported
numbers are consistent with the company’s negative performance. When the same
ratios are restated to reflect the proposed accounting, 1997 appears to be a good
year for Boston Chicken. A discussion of the example raises several issues to be
considered in the policy debate over when to recognize the gain from a decline in
the debtor’s own credit quality.
Imagine a company that just experienced a devastating negative economic shock.
Perhaps its “cash cow” product is rendered useless by a new law or a competitor’s innovation. Or perhaps analysts are questioning the quality of its financial reporting. The
market price of its stock plummets, and its traded bonds now sell at a 60 percent discount from their beginning-of-the-year value. How does this affect the company’s financial statements? Under recently proposed accounting guidance, the company writes
down its bonds payable to fair value, reports the corresponding gain in its income statement, and declares victory in the face of impending disaster.
The proposed accounting can be found in a Financial Accounting Series Special
Report prepared by the Joint Working Group (JWG) of Standard Setters (2000). The
JWG consisted of representatives from Australia, Canada, France, Germany, Japan,
New Zealand, five Nordic countries, the United Kingdom, and the United States, as
well as the former International Accounting Standards Committee. The Special Report I thank the KPMG Foundation and the University of Oklahoma for funding. I thank Evan Shough and
Yinghong Zhang for research assistance, and Mary Barth, Lisa Bryant, Teresa Avery, Eugene Comiskey,
Clyde Stickney, and an anonymous reviewer for comments. Any errors are mine alone. 170 Accounting Horizons/June 2002 represents the majority view of the JWG, and it comes at a time when standard setters
around the world are exploring fair value accounting for all financial instruments. For
example, the Financial Accounting Standards Board (FASB) requires that an entity’s
credit quality be used in determining initial measurements of its liabilities (FASB 2000a,
SFAC No. 7). Moreover, “the Board believes that all financial instruments should be
carried in the statement of financial position at fair value when the conceptual and
measurement issues are resolved” (FASB 1999, para. 3).
This article addresses one of the conceptual issues in fair value accounting for financial instruments—recognizing changes in the fair value of liabilities due to changes
in the debtor’s own credit quality (discussed in JWG [2000, paras. 4.50–4.62]). As alluded to above, if a company experiences a major negative economic shock, then the fair
value of its outstanding debt declines as creditors become skeptical of the company’s
ability to meet its future obligations. Writing down the debt reduces reported financial
leverage, and the corresponding gain increases reported income. If asset impairments
associated with the business downturn are insufficient to offset the liability write-down,
then investors, creditors, and other users of financial statements observe positive signals arising from a very negative event. We will see this exact chain of events using
Boston Chicken’s 1997 financial statements.
I am not the first to raise this issue. The French and German delegations dissented to
the conclusions in JWG (2000) in part because of this issue, and a recent FASB publication
by Crooch and Upton (2001, 1) discusses the “gut-level reaction” by some respondents who
“argue that reporting the effect of changes in an entity’s credit standing is ‘counterintuitive’
or even ‘dangerous.’” Still, conversations with accounting academics and practitioners suggest that many are unaware of the implications of recognizing changes in credit quality in
the financial statements. I use accounting disclosures of Boston Chicken at the onset of
its financial distress to compare financial ratios based on: (1) reported numbers and (2)
the numbers restated to reflect fair value accounting for the company’s debt. The restated ratios provide positive signals despite the negative economic events. A discussion
of several key issues underlying this policy debate follows the numerical example.
EFFECTS OF FAIR VALUING BOSTON CHICKEN’S DEBT IN 1997
In the mid-1990s, Boston Chicken, Inc. was a fast-growing restaurant chain specializing
in fresh, convenient meals featuring home-style entrees, sandwiches, and a variety of freshly
prepared vegetables. Boston Chicken’s 1997 form 10-K reports that 1,166 Boston Market
stores operated throughout the U.S. as of December 28, 1997 (Boston Chicken 1998). The
change in store brand name from “Boston Chicken” to “Boston Market” reflected an expanded
menu. Unconsolidated affiliates, known as “Area Developers,” owned and operated 847 Boston Market stores. Boston Chicken supplied secured debt financing to the Area Developers.
The Area Developers constructed and operated stores within their geographic regions.
They paid Boston Chicken interest and principal on the loans as well as franchise, royalty, and service fees. In addition, Boston Chicken owned a controlling interest in Einstein/
Noah Bagel Corp. (ENBC), which owned 574 ENBC stores as of December 28, 1997.
The initial success of the Boston Market brand came from dinner entrees. In 1996,
Boston Chicken introduced several modifications to their original approach, such as
competing with other fast food chains for lunch-time business. The complexity of the
new endeavors combined with deep promotional discounts resulted in a decline in store
sales in 1997. Since the company’s senior borrowings contained covenants linked to net Fair Valuing Debt Turns Deteriorating Credit Quality into Positive Signals for Boston Chicken 171 average weekly revenue, the 1997 10-K acknowledged the possibility of future default.
The decline in sales spurred Boston Chicken to reduce new store growth and to acquire
controlling equity interests in its Area Developers.
In addition to operating challenges, the company faced criticism of its financial
reporting (Schine 1996). Boston Chicken reported net income of $33.6 million in 1995.
Royalty fees, franchise fees, and interest income, mostly from Area Developers, accounted for $107.9 million of their revenues of $159.5 million. However, supplemental
information showed that the Area Developers incurred $149 million of losses in 1995 as
they rapidly established new stores. On a combined basis, Boston Chicken and its Area
Developers appeared to be incurring losses. Analysts also complained because the company did not disclose same-store sales and classified certain advertising, food, and lease
costs as nonoperating.
While Boston Chicken raises many interesting issues, this article focuses on its
deteriorating credit quality in 1997. Condensed balance sheets and income statements
from Boston Chicken’s 1997 form 10-K appear in Exhibit 1, and excerpts from footnotes
regarding the fair value of debt and income taxes appear in Exhibit 2. At the beginning
of Boston Chicken’s 1997 fiscal year, the carrying value of the company’s debt was
$312.5 million, and the fair value was $395.9 million. The company issued $412.5 million of subordinated convertible debt in April and May. By the end of 1997, the carrying
value of debt was $769.5 million, but the fair value was only $478.7 million. Observing
fair value less than carrying value could be due to market-wide factors such as increases in the risk-free rate, but the risk-free interest rate declined from 6.3 percent in
1996 to 6.2 percent in 1997 (stock-option note in the 10-K). Nor can the decline in the
debt’s fair value be attributed to changes in foreign exchange rates—Boston Chicken’s
debts are denominated in U.S. Dollars. Without a significant change in some marketwide factor during 1997, the decline in the fair value of Boston Chicken’s debt appears
due to deterioration in its own credit quality.
Other indicators reflect the company’s troubles in 1997:
• share price decline from $35 1/8 to $6 17/32 during the fiscal year
$239.7 million loss to common and minority shareholders in 1997, which included:
– $128.0 million provision for losses on loans to certain Area Developers
– $127.4 million of “special charges” for asset write-downs, strategic redirection,
and closing underperforming stores (MD&A in the 10-K)
– investor lawsuits alleging securities fraud (Parker 1997). Clearly, 1997 was a bad year for the company, its stockholders, and its creditors. After
Boston Chicken filed for Chapter 11 bankruptcy on October 5, 1998, its common stock
and traded bonds were delisted from NASDAQ on December 9, 1998. Boston Chicken
eventually completed a reorganization plan in which a subsidiary of McDonald’s bought
the Boston Market stores for $173.5 million on January 13, 2000. Under the reorganization plan, senior secured creditors received substantially less than the face value of
their claims, and investors in the company’s equity and subordinated debt received
nothing (Boston Chicken 2000).
Restating Reported Numbers to Reflect Fair Value Accounting
This section restates Boston Chicken’s financial results assuming the company used
fair value accounting for their debt. Panel A in Exhibit 3 describes reported amounts of
shareholders’ equity and the fair value adjustments. Consistent with a recent Exposure 172 Accounting Horizons/June 2002 EXHIBIT 1
Condensed Financial Statements of Boston Chicken
Panel A: Balance Sheet
Dec. 28, 1997 Dec. 29, 1996 Current assets (includes deferred
taxes of $8,928 and $2,353)
Property, plant, and equipment, net
Other assets $ 124,374
1,350,171 $ 146,462
1,062,406 TOTAL ASSETS $2,005,127 $1,543,616 Total current liabilities
debt—Boston Chicken, Inc.
debt—Einstein/Noah Bagel Corp.
Liquid yield option notes
Senior term loan—Einstein/
Noah Bagel Corp. $ 132,531 $ Total long-term debt
Deferred income taxes
Total liabilities and minority
Common stock—$.01 par value
Additional paid-in capital
Retained earnings (deficit) 417,020 129,841 125,000
197,442 87,633 ––
182,613 24,000 ––
(116,305) Total stockholders’ equity 607,776
$2,005,127 $1,543,616 Dec. 28, 1997 Dec. 29, 1996 $ 462,368
173,179 (211,678) TOTAL LIABILITIES AND
STOCKHOLDERS’ EQUITY 935,840 91,329 Panel B: Income Statement
Total costs and expenses
Income (loss) from operations
Other income (expense):
Interest expense, net
Gain on issuances of subsidiary’s
Other income, net
Total other income (expense)
Income (loss) before income taxes
and minority interest
Income taxes (benefit)
Minority interest in (earnings)
loss of subsidiaries
Net income (loss) (38,209) (14,446) 192
(36,414) 23,854 (248,092)
$ 66,958 Fair Valuing Debt Turns Deteriorating Credit Quality into Positive Signals for Boston Chicken 173 EXHIBIT 2
Excerpts from Boston Chicken’s 1997 Footnotes
5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of
Debt. The fair value of publicly traded debt instruments is based on publicly quoted market
prices. The fair value of ENBC’s senior term loan is based upon the discounted value of the
future cash flows using ENBC’s current cost of capital. The estimated fair values of the
Company’s financial instruments are as follows (in thousands of dollars):
Dec. 28, 1997
Liquid yield option notes
Senior term loan—ENBC*
Total long-term debt
* Dec. 29, 1996 Fair
Value $417,020 $250,599 $129,841 $163,600 125,000
— $769,462 $478,712 $312,454 $395,934 The text above comes directly from Boston Chicken’s 10-K. In the balance sheet in Exhibit 1, the current portion
of the ENBC loan ($6 million) is included in current liabilities, and the remainder appears in long-term debt. 7. INCOME TAXES
The primary components that comprise the deferred tax assets and liabilities at December 29,
1996 and December 28, 1997 are as follows (in thousands of dollars):
Deferred tax assets:
Notes receivable, net
Property and equipment
Accounts payable and accrued expenses
Deferred franchise revenue
Other noncurrent liabilities
ENBC net operating loss carryforward
Total deferred tax assets Dec. 28, 1997 Dec. 29, 1996 $ 75,291
3,943 $ $110,520 $ 24,228 Deferred tax liabilities:
Gain on issuances of subsidiary’s stock
Property and equipment
(8,273) Total deferred tax liabilities $(26,754) $ (45,234) Net deferred tax asset (liability)
Valuation allowance $83,766
(83,766) $ (21,006)
(10,282) — $ (31,288) Net deferred tax liability $ (Continued on next page) 174 Accounting Horizons/June 2002 EXHIBIT 2 (Continued)
As of December 29, 1996 and December 28, 1997, ENBC had net deferred tax assets of $10.3 million and $9.8
million, respectively, both amounts which were fully offset by a valuation allowance due to uncertainty
regarding realization of the related tax benefits. The decrease in the valuation allowance of $478,000 in 1997
was due to the utilization of a portion of ENBC’s operating loss carryforwards, offset by allowances on
deferred tax assets added during 1997. During 1996 and 1997, ENBC utilized $2.5 million and $10.0 million,
respectively, of operating loss carryforwards, which had been fully offset by a valuation allowance. The tax
benefit from the reduction in the valuation allowance has been treated as a reduction of goodwill. ENBC files
a separate tax return from the Company. As of December 28, 1997, ENBC had remaining operating loss
carryforwards available to reduce future taxable income of approximately $6.2 million that begin to expire
in 2010. As of December 28, 1997, the Company had a net deferred tax asset of $74.0 million, which amount
was fully offset by a valuation allowance due to uncertainty regarding realization of the related tax benefits. Draft on liabilities and equities (FASB 2000), minority interest is treated as a component of shareholders’ equity in Exhibit 3 and the computations that follow.
Under the JWG (2000) proposal, debt appears in the 1996 balance sheet at fair
value of $395.9 million, and the amount by which fair value exceeds the $312.5 million
carrying value, an $83.5 million pre-tax loss, reduces shareholders’ equity, as shown in
the first row of the second column of Panel A. By the end of 1997, the debt’s fair value
($478.7 million) was less than its carrying value ($769.5 million), resulting in a cumulative gain of $290.8 million. Under fair value accounting, Boston Chicken will report an
unrealized pre-tax holding gain of $374.2 [ = 290.750 – (83.480)] million for the 1997
fiscal year. Shareholders’ equity increases by this amount, and according to JWG (2000,
para. 380 and para. 6.17), the change should appear in the income statement. The JWG
proposal rejects placing the change directly in shareholders’ equity or in a second performance report, implying that the holding gain should not be a component of Other
Comprehensive Income (OCI). In essence, the JWG endorses a method similar to accounting for trading securities under SFAS No. 115 (FASB 1993) and rejects the approaches for available-for-sale and held-to-maturity investments.
Computing the after-tax gain is more involved. Although the gain affects financial
statement income in 1997, the gain will be included in taxable income when and if realized in the future. With a 35 percent statutory rate, this temporary difference produces a
$131.0 million deferred tax liability. Boston Chicken’s balance sheet contains a net deferred tax asset of $83.8 million and a valuation allowance of the same amount. Because
the $131.0 million credit to deferred taxes results in a net deferred tax liability, the valuation allowance is not needed after the debt is fair valued. Thus, the “Other” column in
Panel A of Exhibit 3 reflects the increase in income due to removing the valuation allowance.1 Adjusted net income for common and minority shareholders (second row, last column) is a profit of $87.3 million rather than the reported loss of $239.7 million. Again,
this figure is before deducting the minority shareholders’ interest in ENBC’s income to be
consistent with FASB (2000). Interestingly, the restated net income in 1997 exceeds net
income reported in the prior two years, $33.6 million and $72.2 million, respectively.
1 The company’s income tax footnote implies that the valuation allowance is determined by the amount of
the net deferred tax asset. If for some reason the company determined that the existing net deferred tax
assets could not be offset by the new deferred tax liability, then the “Other” column in the exhibit disappears. The change in assumptions does not affect the interest-coverage ratio since it is based upon pre-tax
numbers. The debt-to-equity and return-on-equity ratios are .610 and 0.3 percent, respectively, if the
valuation allowance is not removed. As expected, these are more positive signals than the “as reported”
ratios, but less positive than when the valuation allowance is removed. Fair Valuing Debt Turns Deteriorating Credit Quality into Positive Signals for Boston Chicken 175 EXHIBIT 3
Ratio Analysis for Boston Chicken in 1997
(dollar amounts in thousands)
Panel A: Explanations of Adjustments
Stockholders’ Equity Reported Holding Gain or
Loss on Debt Tax Effect
at 35% Other Adjusted 12/29/1996 Balance
1997 Net Income
Other minority interest
Conversion and options 1,089,281
90,727 12/28/1997 Balance 1,056,305 290,750 –101,763 83,766 $1,329,058 Stockholders’ equity and income includes majority and minority interests.
The holding gain = carrying amount of debt minus fair value of debt (see Exhibit 2). This gain increases
equity and decreases liabilities under fair value accounting. The $374,230 is the gain for the 1997 fiscal year,
which is the change in the accumulated unrealized gain or loss for the year.
The tax effect is assumed to equal 35 percent of the holding gain or loss. For a gain, the tax expense
increases, and income and equity decrease. The taxing authority is assumed not to adopt fair value accounting,
so the increase in tax expense is accompanied by a credit to deferred income taxes. Boston Chicken’s tax note
(see Exhibit 2) shows net deferred taxes recognized in the 1997 balance equal zero, so this credit increases
reported liabilities rather than decreases reported assets.
The $83,766 in the “other” column is the removal of a tax valuation allowance. Boston Chicken’s tax note
states that their net deferred tax asset “was fully offset by a valuation allowance due to uncertainty regarding
realization of the related tax benefits.” If the company recognizes the gain on its debt, deferred taxes are
credited for $130,981, resulting in a net liability balance in deferred taxes even after adjusting for the
$29,218 increase in deferred tax assets at the beginning of the period. As such, this valuation allowance is
not needed if the debt is marked to market.
“Other minority interest” is the change in minority interest not included in income. This occurs because
of acquisitions and ENBC’s stock issuance. “Conversions and options” represents increases in shareholders’
equity from issuing stock to option and warrant holders. Panel B: 1997 Reported and Adjusted Ratios
Reported Adjusted Calculation
Interest-Coverage Ratio Calculation Ratio 948,822 ÷ 1,056,305
–239,677 ÷ 1,072,793
–204,177 ÷ 43,915 .898
–4.65 676,069 ÷ 1,329,059
87,339 ÷ 1,182,039
170,053 ÷ 43,915 0.509
3.87 Debt-to-Equity = (total liabilities) ÷ (minority interest + common stockholders’ equity). The increases in
stockholders’ equity described above cause reductions in liabilities.
Interest-Coverage = Net Income before Gross Interest Expense and Tax Expense ÷ Gross Interest Expense.
Gross Interest Expense = $43,915 (disclosed in Boston Chicken’s Note 4). Tax Expense is negative $8,415.
The only adjustment is to add the pre-tax holding gain of $374,230 to the numerator.
Return-on-Equity = net income ÷ [(beginning + ending stockholders’ equity) ÷ 2]. Minority interest is treated
as stockholders’ equity in these computations. 176 Accounting Horizons/June 2002 Comparing Ratios under Existing and Proposed GAAP
Financial statement users rely on amounts recognized in financial statements to provide a representationally faithful view of the company’s financial position and its operations. Ratios such as debt-to-equity, interest-coverage, and return-on-equity are often
used to evaluate a company’s leverage and profitability. Panel B of Exhibit 3 computes
the three ratios using Boston Chicken’s 1997 reported and adjusted numbers. The adjustments to the beginning and ending balances in shareholders’ equity and the adjustments
to net income are explained above and in Panel A of Exhibit 3. As for the other accounts
used in the ratios, the ending balance in debt decreases by the $290.8 million unrealized
holding gain at the end of 1997. A deferred tax liability of $18.0 (101.8 – 83.8) million is
created to reflect the deferred tax consequences of the holding gain net of the removal of
the valuation allowance. Under the JWG proposal, interest expense is based on fair values and market rates. However, without precise information on when rates changed,
deriving a reliable estimate of fair value interest expense is difficult (AAA FASC 2001).
As it turns out, the positive signals from the adjusted interest-coverage ratio are insensitive to reasonable ranges of adjusted interest expense.
The debt-to-equity ratio measures leverage or financial risk, and it is computed in
Exhibit 3 as total liabilities divided by common plus minority stockholders’ equity. Based
on its published 1997 numbers, Boston Chicken has .90 times as much debt as equity.
When the reported numbers are adjusted to reflect fair value accounting, the debt-toequity ratio falls to .51, a decline of more than 40 percent. The improvement reflected in
the adjusted ratio comes from reducing debt and recognizing a gain as the company
experiences financial distress. Moreover, as the probability of Boston Chicken paying
its debts becomes more remote, the debt-to-equity ratio indicates less risk under fair
The 1997 return-on-equity ratio—net income divided by average stockholders’ equity—
using reported numbers is –22.3 percent. After considering the adjustments to the beginning and ending balances in stockholders’ equity and to net income explained in Panel A of
Exhibit 3, the adjusted return-on-equity ratio is 7.4 percent. With the benefit of hindsight, the ratio based on reported numbers seems more representationally faithful.
Analysis of the interest-coverage ratio requires a caveat at the outset. Because the
JWG proposal includes the unrealized holding gain in income and shareholders’ equity,
the effects on the debt-to-equity and the return-on-equity ratios are clear. However, the
traditional numerator in the interest-coverage ratio is earnings before gross interest
expense and income tax expense (EBIT). Will future income statements classify the
holding gain or loss as other income, a component of EBIT? Or will the gains and losses
be reported as a special item near the bottom of the income statement? For purposes of
illustration, the analysis assumes the former. If the latter occurs, then the JWG proposal only affects the interest-coverage ratio via fair value interest expense.
Dividing 1997 EBIT by the gross interest expense of $43.9 million disclosed in Note
4 of the 10-K yields a ratio of –4.65. Boston Chicken reports a loss before interest and
taxes in 1997 more than four times larger than their gross interest expense. If the 2 Book values are often the relevant measures when accounting ratios are used in contracting, such as assessing
the compliance with a debt covenant. Mulford (1985) suggests that if an analyst is interested in assessing the
systematic risk (beta) of a company, then the debt-to-equity ratio should use market values rather than
book values of debt and equity. Using close of fiscal year price times shares outstanding, Boston Chicken’s
1997 debt-to-equity ratio using fair values for debt and common stock was approximately 2.0. Fair Valuing Debt Turns Deteriorating Credit Quality into Positive Signals for Boston Chicken 177 company used fair value accounting with the unrealized holding gain on debt appearing in EBIT, then the $374.2 million pre-tax gain from fair valuing the debt is added to
the numerator of the interest-coverage ratio, and the denominator reflects fair value
interest expense. Using reported interest expense in the denominator as a proxy for fair
value interest, Exhibit 3 shows an interest-coverage ratio of +3.87. Fair value interest
expense generally exceeds historical cost interest expense after a decline in the fair
value of the financial instrument. However, the 1997 difference is likely to be small
because: (1) the change in interest rates due to deteriorating credit quality occurred in
the last half of 1997, and (2) Boston Chicken’s debts do not mature for several years.
Even if fair value interest expense is twice as large as reported interest expense, the
revised interest-coverage ratio is still greater than 1.5. With the benefit of hindsight,
the reported coverage ratio is a more representationally faithful depiction of Boston
Chicken’s ability to cover its debts.
CREDIT QUALITY AND ACCOUNTING POLICY
The example demonstrates how fair value accounting for a real company’s decline
in credit quality can produce unwarranted positive signals in its financial statements.
This section examines some of the key issues facing accounting standard setters and
financial statement users.
Understanding the Gain from Declining Credit Quality
As a first step, the underlying source of the gain from declining credit quality needs
explanation. In Summer 1997, Boston Chicken reported capital of approximately $1,812.3
million, consisting of subordinated debt securities of about $739.5 million and stockholders’ equity of about $1,072.8 million, assuming changes in equity occurred evenly
during 1997. When the bankruptcy restructuring was completed in January 2000, the
holders of the company’s subordinated debt and equity securities lost all of their investment. Under clean surplus accounting, Boston Chicken recognizes losses totaling $1,812.3
million during the period 1997 to 2000. However, the company also realizes a gain of
$739.5 million because the stockholders did not bear all of the company’s losses. In
essence, the gain associated with a drop in the debtor’s own credit quality represents
the amount of the company’s losses in liquidation borne by someone other than the
stockholders. The task facing accounting standard setters is to determine when and
where to recognize the economic gain in the financial statements.
JWG Majority and Minority Opinions
The JWG’s support for market value accounting implies that a portion of the gain is
recognized immediately upon the market discounting the company’s ability to pay its
debts. This is a natural extension of their view that fair value is the most relevant
measure for a financial instrument. In some cases, immediate recognition of gains or
losses can be justified by existing authoritative literature. For example, since the gain
or loss on a traded instrument can often be realized with a phone call, the holding gain
or loss meets the criterion in SFAC No. 5 (FASB 1984, para. 83): “Revenues and gains
generally are not recognized until realized or realizable.”
However, some question if a gain due to declining credit quality is realizable. Consider the following three outcomes from the financial distress:
1. Company management acts quickly and corrects the financial distress. The initial
decline in fair value of the debt is reversed as credit quality rebounds. The gain is
never realized. 178 2.
3. Accounting Horizons/June 2002 The financially distressed company uses its ample cash reserves to repurchase its
bonds at the new lower fair value. The gain is realized in this case.
The stockholders realize the gain concurrently with the complete loss of their investment, as happened with Boston Chicken. Realization occurs in Scenarios 2 and 3, but at the onset of financial distress, the probability of Scenario 2 occurring seems remote. After all, why should the bonds sell at a
discount if the company has that much cash at its disposal?3 Thus, either the gain is not
probable, and therefore not “realized or realizable,” or the company no longer meets the
definition of a going concern. This inconsistency is one of the concerns voiced by the
French and German members of the JWG in their dissenting opinions to the proposed
standard (JWG 2000, paras. A.6 and A.17).
The majority of the JWG justifies immediate recognition of the gain because:
The amount of the shareholders’ residual claim may appear to increase as a result,
but in most cases, an apparent gain from a decline in credit standing will be offset by
the effects of losses and asset write-downs that have caused the decline in credit
standing. (JWG 2000, para. 4.55b) The Boston Chicken example contradicts their prediction. True, the business downturn
in 1997 led Boston Chicken to report asset write-downs and restructuring charges of
$127.4 million and a $128 million provision for losses on Area Developer loans. But the
$374.2 million gain from fair valuing Boston Chicken’s debt is greater than the sum of
these charges. As demonstrated above, applying fair value accounting to Boston Chicken’s
debt results in an estimated 1997 net income of $87.3 million, which exceeds reported
income in either 1996 or 1995.
The JWG (2000, para. 4.55) acknowledges that some people find the recognition of
gains due to the onset of financial distress to be “confusing and counterintuitive.” In
response, they propose to solve the confusion through disclosure:
the net gain or loss resulting from changes in the credit risk of an enterprise’s interestbearing liabilities, both in the reporting period and cumulatively [would be disclosed]
so that users will have the basic information necessary to judge its significance for
themselves. (JWG 2000, para. 4.61) Disclosing the effects of declining credit quality is warranted. Without the fair value
disclosures mandated by SFAS No. 107 (FASB 1991), I could not restate Boston Chicken’s
financial statements to reflect fair value accounting. With appropriate disclosures, a
knowledgeable user can modify reported amounts in the balance sheet and the income
statement to either include or exclude gains and losses from changing credit quality.
If the financial statements are primarily used for setting stock prices in deep and
liquid markets, then prior capital markets research suggests that recognition vs. disclosure does not make a big difference in some cases.4 But recognition vs. disclosure can
produce distinctly different results when recognized numbers are used in contracting.
3 4 Some financially distressed companies successfully negotiate reduced payments. Whether they record a
gain upon renegotiation is currently determined by SFAS No. 15 (FASB 1977). JWG (2000) proposes
recognizing the gain as soon as the bonds fall in value, and at that point in time, the probability of
realizing the gain other than through liquidation seems remote.
Barth et al. (1996) and Nelson (1996) document an association between market prices and fair values of
investment securities disclosed under SFAS No. 107 (FASB 1991). Fair Valuing Debt Turns Deteriorating Credit Quality into Positive Signals for Boston Chicken 179 For example, if changes in the fair value of debt related to credit quality are recognized,
then a bond covenant tied to the debt-to-equity ratio or the level of net worth may not be
violated as the company enters financial distress. Similarly, a bonus plan tied to income
could reward employees as the company falls apart. Thus, recognizing the gain caused
by declining credit quality prior to realization may not provide the most relevant information for all users of general-purpose financial statements.
Some Policy Alternatives
If standard setters ultimately determine that fair value is the best measure for the
statement of financial position, then some of the conflicting signals described above
could be avoided by placing the gain or loss due to changes in credit quality in OCI.
Reporting the gain outside of net income eliminates Boston Chicken’s positive returnon-equity in 1997, although the effect on the debt-to-equity ratio remains the same.
This approach is consistent with SFAS No. 115’s (FASB 1993) accounting for availablefor-sale securities, except that for liabilities, only the credit quality portion of the change
in fair value goes to OCI. Interestingly, the FASB relegated the gain or loss on available-for-sale securities to OCI because: (1) the Board was unwilling to mandate fair
value accounting for financial liabilities, and (2) marking assets but not liabilities to
market through income causes potentially spurious volatility in reported income (SFAS
No. 115, para. 79). By proposing that all financial instruments be marked to market
through income, the JWG hopes to do away with the available-for-sale and held-tomaturity categories in SFAS No. 115.
If standard setters decide to exclude changes in the debtor’s own credit quality from
the proposed fair value standard, then several implementation issues must be resolved.
JWG (2000) correctly points out that when credit quality is low at issuance, initial measurement of the debt must include credit quality; otherwise the credit to bonds payable
does not equal the debit to cash. To isolate credit quality, the company could record: (1)
the debt at present value using the current yield on high-quality debt, and (2) a corresponding discount for the difference between this present value and the proceeds received. This “credit quality” discount is amortized over the life of the instrument, while
the changes in fair value due to shifts in market interest rates or exchange rates are
accounted for using the JWG (2000) proposal. For bonds issued when credit quality is
good, any subsequent change in fair value due to credit quality is isolated and disclosed,
but not recognized. One argument against this approach is that a bond issued when
credit quality is good has a different carrying value from a bond issued when credit
quality is poor. But the difference in carrying values seems more benign than the distortion due to recognizing a gain on the older bond as credit quality deteriorates. Another concern is how to bifurcate the change in fair value between credit quality and
other market-wide factors, but the JWG (2000) disclosure requirements mentioned above
already require this computation.
Analysis of Boston Chicken’s reported and adjusted ratios suggests that financial
statement users need to exercise caution if the recognition of gains on debt at the onset
of financial distress becomes accepted practice. Admittedly, Boston Chicken is an extreme case. Most companies never experience such a severe financial crisis. But major
corporate meltdowns do occur, the most recent and spectacular being Enron’s collapse
in Fall 2001. 180 Accounting Horizons/June 2002 Some may allege that an illustration of fair value accounting for debt based upon
Boston Chicken is tainted because the company did a poor job in accounting for other
items. Had the company used more straightforward accounting for its Area Developers,
the financial crisis might have been apparent before 1997. However, I take the opposite
view. As suggested in JWG (2000), if the accounting for all other items is perfect—internal
and external intangible assets are all recognized in the balance sheet and management
recognizes appropriate amounts of asset impairments—then any positive signals from
writing down debt are likely to be outweighed by other negative signals. But many companies experiencing a sudden, meteoric fall in credit quality also seem to use less than
appropriate accounting (Browning 2002). Thus, the companies most likely to report large
gains from fair valuing debt seem to be the same companies least likely to use appropriate accounting in other areas. Should companies that misapply accounting principles be
required to book gains when their misdeeds are made public?
The analysis in this article pertains to one particular determinant of the fair value
of a debt obligation—the debtor’s credit quality. Requiring fair value accounting for
bonds in response to shifts in market-wide changes in interest or exchange rates could
be justified because a nondistressed company can realize the gain or loss by either
repurchasing the debt or taking an appropriate derivative position. Can a standard be
crafted that requires fair value for all factors other than the debtor’s own credit quality?
The prior section outlined one approach that seems implementable. Admittedly, applying different accounting to credit quality vs. other market-wide factors adds some complexity to the standard. However, to borrow some words from Crooch and Upton (2001,
1), my “gut-level” preference is for policy makers to tackle these issues rather than
produce an accounting standard that “is ‘counterintuitive’ or even ‘dangerous.’” REFERENCES
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