[Editor's note: In light of the recent concerns surrounding Coca-Cola's accounting, the following is an encore presentation of Phil's explanation of Coke's business structure. It was originally published on October 8, 1998.]

TOWACO, NJ (Oct. 12, 1999) -- Coca-Cola's (NYSE: KO) accounting is an issue that gets raised from time to time by both the financial media and those that read the Coke Message Board. The big question is: How does Coke account for its investments in bottlers and is it appropriate?

What amazes me about this query is that the writers generally treat it as if it's some sort of new information. Actually, Coke's method of accounting is nothing new at all. In fact, I touched upon the subject when I wrote the buy report for Coke in early 1998; I first read about the issue in mid-1997; and I've subsequently read articles on it dating farther back.

As a matter of fact, the article in which I first read about the proposed accounting changes stated that the Financial Accounting Standards Board (FASB) had originally intended to implement changes in these rules at the end of 1996. These changes were postponed and have still not been implemented. This means that the issue has been around since at least 1996.

What I'd like to do now is spend a little bit of time explaining the equity method of accounting (as well as other acceptable accounting methods) and give you some sense of how much better Coke's numbers look because it uses this method. At issue is whether Coke should be allowed to announce as earnings any of the sales of its equity ownership in the Coca-Cola bottlers.

There are three ways in which a company can account for the earnings of the companies that it invests in. The first is the same as the method that you or I would use. It's called the "Cost Method" and it records all income as received (generally dividends). Gains or losses are not recognized until the asset is sold or disposed of. These guidelines also require that, in certain situations, an asset be written down to fair market value if it becomes impaired. Generally, the accounting rules require that this method be used when a company owns less than 20% of another company. For reasons I'll discuss later, this is the least preferred method of accounting for such investments.

The second accounting model is the Equity Method. It's used when one company owns more than 20% and less than 50% of another company. Equity accounting involves reporting the income from these investments as a single line item on the financial statements. Coke generally owns less than 50% of its bottlers. As a result, it uses the Equity Method.

The third method is Consolidation. This involves combining financial statements of the parent and its controlled subsidiaries so that the net assets and liabilities of the parent and its subsidiaries are reported together. As a general rule, subsidiaries are accounted for using the consolidation rules when the parent company owns more than 50% of the subsidiary company. This is the preferred method of accounting for investments in other companies.

The issue with Coca-Cola's accounting today revolves around whether there will be any changes made to the Equity Method of accounting. The proposed changes to this model would force Coke to consolidate the results of its bottlers with its own results. The basis for the change relies on the contention that Coke does, in fact, control its bottlers -- even though it owns less than 50% of them.

Now you may be asking yourself, "So what?" To answer that, let's explore the crux of the issue here, the differences between equity accounting and consolidation.

When a company accounts for its investments using the Equity Method, it essentially keeps that investment off of its balance sheet. For instance, let's say that Coke owns 40% of one of its bottlers and that bottler earns $1,000. According to the Equity Method, Coke then adds $400 of income to its bottom line while also increasing the value of its investment in that bottler on its balance sheet by $400.

Let's consider what this means to Coke's income statement first. Over the last three years, Coke's net profit margin has risen to around 20% of sales. During this period, one of its bottlers -- Coca Cola Enterprises (NYSE: CCE) -- had a net profit margin last year of around 1.5% of sales. Since it uses the equity method of accounting, Coke is not required to add to its income statement all the profits AND the costs of its bottlers. That keeps the lower-margin business of the bottlers away from the higher-margin business of Coca-Cola syrup.

Now let's go over to the balance sheet. The business of Coke's bottlers is much more capital intensive than that of Coke. This means that the bottlers generally have a significant amount of capital equipment and debt to finance operations on their balance sheet. Not so for the syrup maker. At the end of 1997, The Coca-Cola Company's cash-to-long-term debt ratio was more than 2:1. In the meantime, the cash-to-debt ratio of the bottler Coca-Cola Enterprises was just 0.006. Ugly. Since Coke uses the Equity Method of accounting, Coke Enterprise's high debt level doesn't impact Coke's balance sheet at all. Its assets also don't impact Coke's return on assets either.

Interestingly enough, if Coke had consolidated its bottlers in 1996 rather than accounting for them using the equity method, its return on equity would have fallen from 61% to 39%; its return on capital would have been 25% rather than the reported 37%. And its cash-to-debt ratio would have fallen dramatically. Additionally, if Coke was forced into consolidation accounting, it wouldn't have been allowed to announce, as income, its $363 million in earnings from the sale of equity investments in its bottlers in 1997. Those sales represented 6% of Coke's total earnings for 1997. In 1996, its equity sales amounted to fully 9% of the company's earnings.

Those are some eye-opening statistics, but let's remember that the way that Coke currently accounts for these investments is well within the current accounting rules. I personally have no problem with a company following the rules in a way that enhances their financial statements -- again, provided that it is done in a legal and consistent fashion. It has been and is at Coke. The same accounting rules are used in other businesses. We must all remember that no business is responsible for accounting for its entire chain of suppliers and distributors. That Coke owns minority stakes in its distributors... well... it's just smart.

Have a Foolish evening,

Phil Weiss