What’s more, the CDIs — the accounting for which is governed by the new staff position — will not be eligible for the “fair value option” under FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. Accordingly, these instruments may not, at the issuer’s election, be “marked to market” with the resulting change in carrying amount reflected in earnings.
Additional Interest Expense
The effect of bifurcation will be felt by issuers where it matters most — their reported earnings.** Thus, the excess of the principal amount of the liability component over its (truncated) carrying amount is amortized to interest cost using the “interest method.” In these cases, both debt discount and debt issuance costs are amortized over the expected life of a similar liability that does not embody an associated equity component. This expected life is not reassessed in subsequent periods unless the terms of the CDI are modified. Moreover, the equity component is not remeasured as long as it continues to meet the conditions for equity classification.
If a CDI is “de-recognized,” an issuer allocates the consideration transferred and the transaction costs incurred to, (1) the extinguishment of the liability component; and (2) the re-acquisition of the equity component of the bifurcated CDI. Any difference between the consideration attributed to the liability component and the sum of the carrying amount, and the unamortized debt issuance costs is recognized in the income statement as a gain or loss. Meanwhile, regarding the reacquisition of equity component of the CDI, the issuer is required to recognize the settlement consideration as a reduction of stockholders’ equity.
FSP APB 14-1 is effective for financial statements issued in fiscal years beginning after December 15, 2008, as well as for interim periods within those fiscal years. Moreover, the staff position is to be applied retrospectively to all periods presented. This is true even though the CDI being accounted for was issued well before FASB even raised an issue with respect to the accounting for instrument C. The cumulative retrospective effect of the accounting change related to prior periods is recognized as of the beginning of the first period presented. Also, an offsetting adjustment must be recorded to the opening balance of retained earnings for that period.
The FSP, of course, has no effect on the tax treatment of the instruments affected by the new guidance. In fact, for tax purposes, bifurcation of a convertible instrument is explicitly prohibited: The regulations provide that “…the issue price of a debt instrument includes any amount paid for an option to convert the instrument into stock (or another debt instrument) of either the issuer or a related party…or into cash or other property in an amount equal to the approximate value of such stock (or debt instrument)…” See Regulation Section 1.1273-2(j).