A Fair Value Prescription for “Share Lending”

If it's probable that the deal's investment bank will default, the issuing company must recognize an expense equal to the fair value of the unreturned shares, says FASB.

There are times when a company finds that the cost of borrowing its own shares is “prohibitive.” When that happens, a company may, and frequently will, enter into a share lending arrangement in connection with a convertible debt offering. The accounting treatment for such a transaction has been clarified by the Emerging Issues Task Force of the Financial Accounting Standards Board, which recently reached consensus on the manner in which certain specialized share lending arrangements are to be accounted for.1

The share lending arrangement ordinarily entails an agreement between the issuing entity and an investment bank and is intended to facilitate the ability of investors (primarily hedge funds and other sophisticated investors) to hedge the conversion feature with respect to the convertible debt.

Typically, the terms of the share lending arrangement require the company to issue shares to the investment bank in exchange for a nominal “loan processing fee.” Upon the maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to the issuing entity for no additional consideration. Moreover, the investment bank is generally required to reimburse the issuing entity for any dividends paid on the loaned shares and is prohibited from exercising the voting rights associated with the loaned shares.

The new guidance, EITF Issue No. 09-1, says that at the date of issuance, a share lending arrangement is required to be measured at fair value and recognized as a “debt issuance cost” in the financial statements of the issuing entity. No guidance is provided regarding how the fair value is to be ascertained. The debt issuance cost is then amortized, under the “effective interest method,” over the life of the financing arrangement, as interest cost.

Bob Willens 2“At the date of issuance, a share lending arrangement is required to be measured at fair value … [but] No guidance is provided regarding how the fair value is to be ascertained.”— Robert Willens

If it becomes probable that the counterparty (the investment bank) will default, the issuer shall recognize an expense equal to the then fair value of the unreturned shares — net of the fair value of any probable recoveries — with an offset to the issuer’s additional paid-in capital (APIC) account.

The loaned shares are excluded from both the basic and diluted earnings per share computation unless default is found to be probable. When default is probable, the loaned shares would be included in the earnings per share calculation. Moreover, if dividends on the loaned shares do not revert back to the issuing entity, all amounts (including contractual dividends) attributable to the loaned shares shall be deducted in computing “income available to common shareholders,” which is consistent with the “two-class method” of computing earnings per share.2

This EITF Issue will be effective for fiscal years which begin after December 15, 2009, and for interim periods within those fiscal years.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com

Footnotes
1 See EITF Issue No. 09-1, Accounting for Own Share Lending Arrangements in Contemplation of Convertible Debt Issuance.
2 See FAS No. 128, Earnings per Share.

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