Convertible Bond Rule Targets Earnings

The verdict is in on "Instrument C" bonds, and all is not rosy.

The Financial Accounting Standards Board (FASB) has finalized its “guidance” with respect to accounting for some immensely popular convertible instruments known as “Instrument C.” The problem, however, is that the news, as everyone suspected, is decidedly negative.*

Many of the accounting advantages these instruments previously enjoyed will be unceremoniously eliminated and, to make matters worse, the new accounting model with respect to these instruments will be applied “retrospectively” to all periods presented.

The vehicle for this radical alteration is FSP APB 14-1,Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement). The FASB staff position applies to convertible debt instruments (CDIs) that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement. Moreover, convertible preferred shares that are treated as “mandatorily redeemable financial instruments,” and are classified as liabilities under FAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, are considered, for purposes of this staff position, CDIs.

Most notably, CDIs within the scope of this staff position are not addressed by paragraph 12 of APB Opinion No. 14 — they will not, therefore, be accounted for as “unitary” debt instruments. Instead, the liability and equity components are accounted for in a manner that will reflect the entity’s non-convertible debt borrowing rate when interest cost is measured in subsequent periods. In short, the dreaded remedy of bifurcation has been selected for instrument C. That is, under the new guidance, issuers of instrument C type debt must record the debt and equity components separately.

Allocating Issue Price

The issuer of a CDI covered by this staff position has to first determine the carrying amount of the liability component by measuring the fair value of a similar liability that does not have an “associated equity component.” The issuer then has to determine the carrying amount of the equity component by deducting the fair value of the liability component from the initial price of the CDI.

Transaction costs, says the staff position, are allocated to the liability and equity components of the bifurcated CDI in proportion to the allocation of issuance proceeds. Further, these costs should be accounted for as “debt issuance costs” and “equity issuance costs,” respectively. The FSP notes that recognizing CDIs as two separate components may result in a basis difference (between the carrying amount of the liability component and the “tax basis” of such liability) that represents a temporary difference within the meaning of FAS No. 109,Accounting for Income Taxes.

So, in most cases, a deferred tax liability will be recorded to reflect the tax effect of this basis difference. In addition, the FSP states that the initial recognition of deferred taxes should be recorded as an adjustment to “additional paid-in capital.” In other words, the “debit” is a charge to APIC.

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