Criteria & Methodologies

Our objective is to use an amortized cost concept for reflecting debt in our measures, consistent with the amortized cost method employed under IFRS and U.S. GAAP. This method reflects debt at the amount of original proceeds, plus interest calculated using the effective interest rate, less payments of principal and interest made. At issuance, the effective interest rate is the yield that equates issuance proceeds and future cash payments. This rate is consistent over the term of a fixed-rate obligation. For variable-rate obligations, the effective rate after issuance will vary each time the coupon rate is reset. Under this amortized cost method, interest expense is measured at the full cost of the borrowing.

The approach is adapted to also apply to our analysis of debt obligations that give the holder the option of converting an issuer's debt to shares. Such obligations normally pay below market interest in exchange for the option to convert to equity. In our ratios, we seek to include the full effective cost of the obligation as interest. This is approximated by the "split accounting" methodology under IFRS, which requires the value of a convertible debt obligation to be split to a debt component (that is, the fair value of a similar debt obligation without the conversion feature), accounted for as debt, and the embedded conversion feature (the difference between the debt component and the issue price), accounted for as equity (see "Beyond Reported Debt: Corporate Financial Obligations Under IFRS," published April 25, 2005, on RatingsDirect). Where split accounting has not been applied, as is often the case for convertible instruments under U.S. GAAP, for example, we seek to approximate this amount, by increasing reported interest expense when the difference is significant.

We typically reflect the entire convertible obligation (inclusive of the value of the conversion option) as debt under our hybrid methodology. Therefore, where split accounting has been applied, we add the equity component to debt to approximate an amortized cost amount of debt.

As part of our case-study scenario, we've considered a number of variations to the bond's hypothetical coupon and market rate.

For issuance at a premium, interest expense recorded is lower than the stated coupon by the amount of premium amortization. For debt that carries a variable-rate coupon, the effective rate is adjusted at each repricing date. The amortized cost method ensures that interest expense continues to reflect the full cost of the borrowing as contracted at issuance.

For a payment-in-kind (PIK) note that bears the market rate (8% in this example) and is issued at face value of $100,000, interest would accrue over the term, payable at maturity. After year 1 in the above example, the carrying value would be $108,000, comprised of face value and accrued interest. The reported amounts are also the measures we endeavor to use in our analysis ($108,000 for debt and $8,000 for interest expense).

Similarly, a zero-coupon bond will be issued at a discount to face value. A five-year zero-coupon bond with a face value of $100,000 issued when the market rate is 8% will be recorded at $68,058 at issuance (assuming annual compounding). After one year its "book" value is $73,503 ($68,058 multiplied by 1.08), with $5,445 recorded as interest expense. After two years it is recorded at $79,383 (73,503 multiplied by 1.08) and interest is $5,880, and so on until maturity when it reaches face value of $100,000. We endeavor to use these values in our analysis.

Issuance costs are normally small in relation to the debt amount, and are typically included as a deduction to the original issue proceeds (reported as debt on the balance sheet). As a result, these costs are also included in the amortized cost basis of calculating interest expense. In some cases the debt value may even be reduced by premiums paid to refinance an earlier debt obligation. For these obligations, the refinancing is treated as a debt exchange rather than extinguishment and new issuance, and--as such--the redemption premium is deferred rather than recognized immediately as a loss on debt extinguishment. We would prefer to adjust debt and interest expense for any unamortized issuance costs (and refinancing premiums), essentially writing off these costs. However, such adjustments typically are not practical because the amounts are not distinguished in company disclosure.

Applying this methodology is unlikely to have any rating implications. Our adjustments to debt and interest merely address in a quantitative fashion certain characteristics of debt instruments that have already been factored into our rating analysis through a variety of quantitative measures and qualitative assessments. For example, the low interest expense shown for convertible instruments issued by companies that report under U.S. GAAP is well understood in our analysis of the resulting higher interest coverage ratios. These ratios will decrease under the revised methodology, but this is not new information relative to the overall rating analysis.

We expect that accounting methods will increasingly require or allow fair value measurement of debt obligations (not just disclosure, which already applies). For the time being, subject to the practical difficulties explored in this article, we consider it appropriate to recast these to amortized cost to capture the full cost of the borrowings outstanding, addressing liquidity and refinancing separately. However, if the use of fair value in accounting extends to even more debt obligations, there may come a point where this position is no longer sustainable from a practical standpoint. We will of course continue to monitor accounting developments and express our analytical views to the accounting standard setters on this topic.

The following table summarizes Standard & Poor's adjustment methodologies for a number of accounting methods used in reporting traditional financial debt obligations.

Accounting method	Accounting description	Standard & Poor's-adjusted debt measure: amortized cost	Standard & Poor's-adjusted interest expense: based on the market rate at issuance	Standard & Poor's-adjusted interest paid: cash amount paid
Amortized cost	Reported debt may include a component related to unamortized discount, premium, or issuance costs. Reported interest expense reflects the full cost of the borrowing by including amortization of any premium or discount.	Reclassify to debt any accrued or prepaid interest included in another line on the balance sheet (such as accrued expenses). Remove significant unamortized issue costs, if practical.	No adjustment, unless amortization of issue costs is significant and removing them is practical.	No adjustment.
Fair value hedge accounting	Once the amortized cost is calculated a further adjustment is made to debt for the fair value of the risk hedged (for example, the risk of fixed-rate debt relative to changes in market interest rates).	The amortized cost amount may not be available in the financial statements. It may be possible to determine the amount of the fair value adjustment made to reported debt as a consequence of hedge accounting, and reverse it. Alternatively, we might be able to estimate the amount based on the fair value of the related derivative hedge instrument, or we may adjust debt to reflect the amount originally received as proceeds, or even face value, plus accrued but unpaid interest.	No adjustment. Reported interest expense reflects the market rate achieved at issuance. (The impact of the derivative{s} in converting this to a hedged rate of interest is also included.)	No adjustment (unless it is necessary to include the derivative cash flow in operating cash flows together with the interest paid).
Fair value option	Debt can be fully adjusted to fair value under IFRS or U.S. GAAP. Generally, the amount included in interest expense is based on the current market rate of interest (as contrasted with the effective interest rate in the above examples).	The amount of amortized cost may not be available in the financial statements. As an alternative, an estimate may be used based on the amount originally received, or the face value, plus accrued but unpaid interest.	Particular care is given to determining whether interest includes a charge/benefit for instruments marked to market under the fair value option and, if so, how it was measured (as the periodic remeasurement to fair value may serve to distort the expense amount). From a practical standpoint, however, it is difficult to adjust.	No adjustment.
Business acquisition	Debt is brought to fair value when the entity that issued it is acquired. The debt is then amortized.	No adjustment (unless to reclassify accrued interest). We consider the fair value at acquisition to appropriately represent the issuance value to the new owner.	No adjustment. Interest expense generally includes amortization related to the fair value adjustment at the time of the acquisition, and therefore represents the full cost of the borrowing.	No adjustment.

The following table summarizes Standard & Poor's adjustment methodologies for specific characteristics of traditional debt obligations.

Characteristic	Accounting	Standard & Poor's-adjusted debt measure: amortized cost	Standard & Poor's-adjusted interest expense: based on the market rate at issuance	Standard & Poor's-adjusted interest paid: cash amount paid
Foreign currency-denominated bonds	The amortized cost is translated at the spot exchange rate as of the balance sheet date.	No adjustment (unless to reclassify accrued interest).	No adjustment (unless one is necessary to remove foreign exchange gains and losses on the translation of the debt from reported interest expense).	No adjustment.
Convertible bond--split accounting	Part debt, part equity.	For the amount treated as debt we typically add to reported debt the value of the conversion option included in shareholders' equity. Where the sum of the two components significantly exceeds face value because of the accretion of the debt component through the life of the instrument, we may adjust the reported debt component to the face value plus any accrued (unpaid) interest.	For interest on the amount treated as debt there is no adjustment. The split accounting results in interest expense approximating the full cost of financing.	For interest on the amount treated as debt there is no adjustment.
Convertible bond--no split accounting	Amortized cost.	For the amount treated as debt there is no adjustment (unless to reclassify accrued interest).	For interest on the amount treated as debt we seek to adjust the period's expense, where practicable, to equal the instrument's discounted debt component (for the equivalent nonconvertible instrument) multiplied by the company's refinancing rate at the convertible bond's issuance date. Where this is not feasible, we may approximate the amount based on the face value of the obligation.	For interest on the amount treated as debt there is no adjustment.
Zero-coupon bonds and PIK notes	Amortized cost.	No adjustment (unless to reclassify accrued interest).	No adjustment. Interest expense reflects the full rate achieved.	No adjustment.
Indexed bonds	Principal and interest increase (or decrease) with reference to an index (the consumer price index, for example).	No adjustment (unless to reclassify accrued interest).	Interest expense may vary over time in accordance with changes in the index, affecting both principal and the interest coupon. All indexation is considered interest expense under our methodology.	No adjustment.
Hybrids other than convertible bonds	May be accounted for as equity or debt.	The amount we classify as debt under the hybrid methodology (subject to 100% or 50% treatment, as applicable) would be measured as above--at amortized cost.	If accounted for as debt, the same points apply as for other convertible debt instruments (mentioned above). If accounted for as equity but treated as debt under our hybrid methodology, we will treat dividends accrued in the period as interest expense, unless in a particular case there is a better basis for accruing the full cost of capital (the accounting models for accruing interest and dividends differ).	If accounted for as equity but treated as debt under our methodology, we will treat dividends paid during the period as interest paid.

These criteria represent the specific application of fundamental principles that define credit risk and ratings opinions. Their use is determined by the issuer-specific or issue-specific facts, as well as Standard & Poor's assessment of the credit and, if applicable, structural risks for a given issuer or issue rating. Methodology and assumptions change from time to time as a result of market and economic conditions, issue-specific or issuer-specific factors, or new empirical evidence that would affect our credit judgment.