The Financial Accounting Standards Board, or FASB, has decided that the current method of accounting for certain convertible debt instruments is both inappropriate and patently misleading. Accordingly, the board is moving ahead with what can be described only as a radical overhaul of the rules for these securities, known as cash-settled convertibles. Issuers of the popular instruments will have to report substantially more interest expense. Issuance is likely to slow dramatically and perhaps cease altogether.
The formal vehicle for this revision is FASB Staff Position (FSP) No. APB 14-a, entitled "Accounting for Certain Convertible Debt Instruments That May Be Settled in Cash Upon Conversion." As usual, FASB has invited the public to comment on, and suggest alterations to, the conclusions it has reached. At this point, however, it seems that FASB has already considered any changes that the public might suggest -- and summarily rejected them, regardless of their volume and tenor. So unless FASB suddenly and surprisingly reverses course, the conclusions expressed in FSP No. APB 14-a will become, intact, the latest addition to generally accepted accounting principles, or GAAP.
The security that prompted this new pronouncement is a convertible debt instrument known in accounting circles as Instrument C. The salient feature of Instrument C is that, on its conversion to equity, the issuer of the security must satisfy the "accreted value" of the obligation in cash, and may satisfy the "conversion spread" in either cash or stock. The accreted value is an amount equal to the security's original issue price, increased by the amount of accrued original issue discount or decreased by the amount of accrued issuance premium. The conversion spread is the amount by which the conversion value of the instrument exceeds its accreted value.
An earlier ruling (specifically, Emerging Issues Task Force Issue No. 90-19, "Convertible Bonds with Issuer Option to Settle for Cash Upon Conversion") directed that Instrument C be accounted for "like convertible debt." For issuers, this was a favorable outcome. It meant that no portion of the issue price of the security would be allocated to its equity component because the instrument was seen as a unitary debt instrument rather than as an agglomeration of debt and equity components.
This, in turn, meant that the interest expense the issuer would report would not be augmented by the amortization of original-issue discount. Instead, the interest cost to be reported would be based solely on the instrument's stated yield. For most issuers, that yield is a lower one than purchasers would demand if it were borrowing via straight debt instruments; the buyers, of course, are getting an embedded equity option instead of a higher interest rate. This favorable accounting treatment, unfortunately, will no longer be available for a broad swath of convertible securities.
The revisions introduced by the FSP will apply to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion. Where this exceedingly common settlement option is present, the FSP proposes the radical remedy known as "bifurcation."
The rule calls for the liability and equity components of the security to be separately accounted for in a manner that is designed to "accurately reflect the issuer's nonconvertible debt borrowing rate when interest cost is recognized in periods subsequent to the issuance of the security." In implementing this directive, the issuer is required first to determine the carrying amount of the liability element of the bifurcated instrument by measuring the value of a similar liability that does not contain an equity component.
Thus, because the liability component of a convertible instrument carries with it a below-normal interest rate, the initial carrying amount of the liability component will inevitably be far below its principal amount. The carrying amount of the equity aspect of the bifurcated instrument will be determined under the "residual method." Such carrying amount, therefore, will be an amount equal to the proceeds obtained upon the issuance of the security, minus the fair market value of the liability component of the instrument.
The FSP goes on to provide that the excess of the principal amount of the liability component of the instrument over its fair market value at the time of issuance shall be amortized to interest cost, using the "interest method" of accounting. Thus, the amount of interest expense the issuer will record will be the sum of the cash interest payments made with respect to the security, plus the amortization of the original issue discount at which the liability component of the instrument will be deemed to have been issued.
The end result is that the issuer's earnings will be penalized by the need to record an amount of interest expense (net of tax benefits) that is substantially in excess of the instrument's stated yield. The FSP provides that this original issue discount shall be amortized, as a charge against earnings, over the "expected life" of a similar liability that does not have an equity component embedded within it.
The provisions of the FSP are slated to be effective for financial statements issued for fiscal years that begin after December 15, 2007. This effective date is deceptive, though, because the FSP must be applied retrospectively with respect to "all periods presented" in the report.
Because of the retrospective provision, the accounting for instruments that were issued well before the FASB began its deliberations on Instrument C will have to be altered as well. Finally, even periods before those presented will be affected. The additional interest expense that would have accrued in those periods will reduce the issuer's opening balance of retained earnings.
It seems clear that issuers will become extremely reluctant to float cash-settled convertible debentures. However, we have it on good authority that the product specialists at some of Wall Street's major investment banks are hard at work designing an alternative security for issuers to consider -- one that promises to have a much more favorable accounting profile. - Robert Willens
Robert Willens is a managing director and tax and accounting specialist at Lehman Brothers Inc. He is also an adjunct professor of finance at Columbia Business School.
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