To be sure, Instrument X solved one of Instrument C’s big problems: to get the EPS benefit, a company had to keep enough cash on hand to pay off the par value of the bonds when investors exercise their conversion option. Unlike with a traditional bond, which allows treasurers to schedule related cash flow until maturity, Instrument C issuers didn’t have control over the bond’s payout schedule, as investor conversion could occur at any time. “That’s a problem for companies that have liquidity issues, even if cash-flow problems don’t emerge until 20 years after the date a 25-year bond is issued,” said Comerford in a recent interview with CFO.com.
As a fix, Instrument X put settlement specifics in the hands of the issuer. Accordingly, when investors exercise their call option, the issuer decides whether to repay the bondholder in cash, stock, or a combination of both. But from an accounting perspective, it seemed that the issuer would no longer qualify for the more favorable treasury stock method, and instead would be forced to use the if-converted method. The resulting assumption would be that some, if not all, of the bond would be settled in shares — the exact result issuers were trying to avoid.
But thanks to a FAS 128 loophole, issuers of Instrument X were allowed to sidestep the conventional accounting treatment. Comerford explains that FAS 128 states that if a company has a past history or stated policy of settling a convertible bond in cash any time it is given a settlement choice, then it can assume cash settlement rather than share settlement for accounting purposes. In his 2003 speech, Comerford addressed SEC concerns about the loophole; mainly that a company’s stated policy or past practice of cash settlement had to be substantive.
For example, a company’s argument would lack substance if management claimed that despite struggling to pay its bills, the company had the ability to settle millions of dollars worth of Instrument X debt in cash, says Comerford. He adds that while there was no specific instance of abuse that prompted the speech, the SEC staff was concerned about the way the accounting guidance “hinged on management’s intention,” and wanted to reiterate to issuers the existing accounting guidance.
At the time, FASB was already discussing closing the Instrument X loophole, but the exposure draft was delayed several times as the standard-setter struggled with international accounting convergence issues, as well as with trying to address EPS guidance holistically, rather than one issue at a time.
With the release of the exposure draft this month, FASB has proposed to close the international accounting gap with respect to EPS guidance. FAS 128 is nearly identical to IAS 33, its international counterpart, in terms of how the metric should be calculated. However, FASB has not set a date for releasing the final draft, says Wyatt, as board members want to review the public comments before they decide how much work is still ahead of them.
Nevertheless, Comerford seems sure about one thing: if the EPS advantage is eliminated, Instrument X will survive only as long as treasurers see an advantage in having settlement flexibility. But he doesn’t expect that benefit to save the bond from extinction.
Furthermore, Willens asserts that investment bankers are probably studying the accounting literature now to dream up new convertible bond products that produce coveted accounting benefits. Perhaps an Instrument Z will be out for the holiday season.