Financial Reporting Presents: Accounting for · PDF filedebt instrument will always require...

Accounting for Convertible Instruments: An Overview

Rob ComerfordJames BarkerMichael MuellerSara Glen

April 24, 2007

Financial Reporting Presents:

Copyright © 2007 Deloitte Development LLC. All rights reserved.

Agenda

• Overview of Accounting Risk and Complexity of Convertibles

• Accounting for Traditional Convertibles

–APB 14 Model–Evaluation of Conversion Option under FAS 133

• What We Didn’t Tell You…


Learning Objectives

At the end of the webcast, participants should understand• the accounting risk and complexity associated with

convertible instruments• the accounting for plain-vanilla convertible debt

under APB Opinion 14• the steps involved in evaluating the embedded

conversion option in plain-vanilla debt for separation under FAS 133


Keep in Mind

• This webcast does not provide official Deloitte & Touche LLP interpretative accounting guidance

• Don’t expect this webcast to turn you into a convertibles expert

• Don’t think about this stuff while driving your convertible

• Seriously, try to have some fun with this stuff because, otherwise, you’ll look like this guy…


Polling Question #1

In what role have you worked with convertible instruments?

• As the investor in the instrument• As the issuer of the instrument• As the adviser• As the auditor• Don’t know / not applicable


Overview

Main Entry: con·vert·iblePronunciation: kuh n-vur-tuh-buh lFunction: adjective

Merriam-Webster’s Online Dictionary

1 : capable of being converted <a bond convertible to 12 shares of common stock>

2 : having a top that may be lowered or removed <convertible coupe>

1


Overview

Back then (1969)…

Convertible into a fixed # of shares

Standard antidilution provisions

If-converted method

Convertible Debt

2


Overview

Why the if-converted method is not popular…

200WASO$1.00=

$200=

NIBasic EPS =

3

• Net income = $200, WASO = 200• $1,000 bond (coupon = 6%, conversion price = $10)• Tax rate = 40%, Avg. Share Price = $7

Example

300WASO + Assumed Shares$0.79=$236=NI + After-Tax InterestDiluted EPS =

Dilutive even if conversion

option is out of the money!


Overview

…Today (2007)Contingently convertible

Conversion spread settled in net shares, principal settled in cash

Non-standard antidilution provisions

Treasury stock method

Instrument C

4


Overview

CONVERTIBLES – Accounting Challenges

Attractiveness of ConvertiblesIssuer: Low cost financingInvestor: Upside potential

Product Complexity

Too many form-driven rules in too many places in GAAP

# ofRestatements

Accounting Complexity

CoCos, Instrument C, Instrument X, other features to minimize EPS/ economic dilution…

5


Overview

“[In 15% of the restatements in filings from 2003 to 2005], one or more attributes of the accounting literature seem to have been an underlying factor that contributed to the error. Errors that had such contributing factors most often involved financingtransactions such as the issuance of convertible securities with beneficial conversion features and the issuance of equity instruments to third parties. In some cases the troublingattribute seems to be a lack of clarity in standards, while in others, it was difficulty in identifying all of the relevant accounting literature, and in others, it was the complexity of the literature that contributed to the error.”

Scott A. Taub, Acting Chief Accountant for the U.S. Securities &Exchange Commission (Financial Executives International Meeting,New York, November 17, 2006)

6


Overview

Information compiled from Audit Analytics, 2006 Financial Restatements – A Six Year Comparison (Audit Analytics Briefing: February 2007)

1,599

329

1,876

511

0250

500

750

1,000

1,250

1,500

1,750

2,000

2005 2006

Restatements in 2005 and 2006: in the aggregate +debt/equity related

27.2%20.6%

7

Single largest

category!


Polling Question #2

Do the statistics we just shared surprise you?

• Yes, I had no idea that convertible instruments could cause so many restatements.

• No, I’ve known about the complexities of convertibles for awhile.


Overview

… Need to identify embedded derivatives and evaluate them for separation under FAS 133

… Need to determine host contract and recognize that it might change

… Need to determine accounting for host contract and separated embedded derivatives

… Need to determine EPS impact

Complex because…

Initially and Subsequently!

8


Overview

Debt Host(“Host Contract”)

Hybrid, host, embedded feature…

Conversion Option(“Embedded Feature”)

Convertible Debt (“Hybrid Instrument”)

9


Overview

Hybrid, host, embedded feature…

$950

$50

$1,000

10

$1,000DR. Cash

$1,000CR. Debt

$50CR. Derivative Liability

$50DR. Debt Discount

Initial Accounting

Derivative liability remeasured at FV, with changes in FV being recorded in P/L

Debt discount accreted to interest expense via effective yield method

Subsequent Accounting

(Example ignores issue costs)


Traditional Convertibles: APB 14

• Convertible into issuer’s stock at investor’s option

• Conversion price is fixed

• Initially, conversion price > FV of issuer’s common stock

• Not issued at a substantial premium

Let’s start at the beginning…

OK if adjusted for STANDARD anti-dilutive events

11


The story about the frog prince…

+ =

+ =


12



Basic EPS: Exclude unless converted.

Diluted EPS: Use if-converted method.

EPS(FAS 128)

Treat convertible debt as straight debt.

Present discount (premium) as a deduction from (addition to) face amount. Capitalize issue costs.

Accrete discount (premium) and issue costs using interest method.

Accounting(APB 12, 14, 21)

I like the frog prince story…Do we really need to talk about accounting?

Critical terms (maturity, conversion terms, effective interest rate, voting rights, participation rights, call prices and dates, etc.)

Disclosures(FAS 129)

13


Traditional Convertibles: FAS 133

Bifurcation required?

Derivative criteria met?

Scope exception?

Conversion Option – To B or not to B(ifurcate)?

14



12c: If freestanding, derivative?

12b: Hybrid = Not marked to market under other GAAP?

12a: Not clearly and closely related to debt host?

6c: Net settleable?

11a: Qualify for Scope Exception?

6b: Small initial net investment?

6a: Underlying, notional?

EITF 00-19: Classified in Equity?

EITF 01-6: Indexed to Issuer’s Own Stock?

Does the conversion option in plain-vanilla debt require bifurcation from debt host?

15


Polling question #3

Test question: Which of the following is NOT a characteristic of traditional convertible debt?

• Debt or equity participation are mutually exclusive outcomes.• Exercisability of conversion option is contingent upon market price triggers.• Conversion price is fixed.• Convertible is not issued at a substantial premium.• Don’t know. Didn’t expect to get quizzed this early.






6c: Net settleable?







16



Accounting bifurcation? But, legally it’s one instrument!

The conversion option requires bifurcation if…

The conversion option is NOT clearly and closely related to the debt host, AND

The hybrid instrument is not already marked to market through earnings under GAAP other than FAS 133, AND

The conversion option would be a derivative if it were a freestanding item.

17



Example

• A issues a $1,000 bond that is convertible at any time into 100 shares of A’s common stock.

• A’s common stock is actively traded onNASDAQ (avg. trading volume = 10,000 shares)

• At the issuance date, A’s stock was trading at $7 per common share.

18



12a: Not clearly and closely related to host?

On the road to bifurcation…

Changes in FV of conversion option and interest rates on debt are NOT clearly and closely related to debt host.

Let’s look at our example

19



A issues $1,000 bond, convertible into 100 shares of A’s actively-traded common stock

$1,000

Stock Price$10

Payoff

Host

Conversion Option

Conversion option is NOT clearly and closely related to NON-CONVERTIBLEhost contract.

20



12b: Hybrid = not marked to market?


But remember: FV election under FAS 155 or FAS 159

Current GAAP in APB 14 does not provide for FV remeasurement of convertible debt.

21






6c: Net settleable?







22



12c: Conversion option = derivative?

23

See next slide…6c: Net settleable?

Yes, FV of conversion option < initial FV of underlying shares, by more than a nominal amount


Yes, # of shares of A’s common stock into which debt can be converted

6a: Notional?

Yes, market price of underlying shares of A’s common stock

6a: Underlying?

Element Present?Elements of a Derivative




24

Yes, A’s stock is publicly traded and # of shares could be rapidly absorbed by market w/o significantly affecting the price.

• 9c: Are underlying shares readily convertible to cash?

No.• 9b: Can conversion option be net settled via a market mechanism (e.g., an exchange)?

No, explicit gross settlement (A delivers the shares underlying the conversion option in exchange for debt instrument).

• 9a: Can conversion option be explicitly net settled (=neither party must deliver an asset related to underlying and equal in quantity to notional)?

6c: Net settleable:

Element Present?Elements of a Derivative



Polling question #4

Test question: A conversion option embedded in a debt instrument will always require bifurcation from the debt host.

True or false?• True

• False• Don’t know, you better curve this test.






6c: Net settleable?







25



Help is on the way: The “11(a)” scope exception…

26

Indexed to Issuer’s Own Stock (EITF 01-6)?

Classified in Equity (EITF 00-19)? Bifurca

tion





1. If contingently, exercisable, is the contingency appropriate?; AND

2. Once contingency has occurred, is thesettlement value based solely on the issuer’s stock price?

Potential problem area for complex convertibles!

27



A issues $1,000 bond, convertible into 100 shares of A’s actively traded common stock

$1,000

Stock Price$10

Payoff

Host

Conversion Option

Conversion option is indexed to A’s common stock (settlement value is based solely on A’s stock price).

28





Classified in Equity (EITF 00-19)?

What does this mean?

1. If contingently exercisable, is the contingency appropriate?; AND


29



As defined in EITF 00-19:

• Physical Settlement – the party designated in the contract as the buyer delivers the full stated amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer

• Net-Share Settlement – the party with a loss delivers to the party with a gain shares with a current fair value equal to the gain

• Net-Cash Settlement – the party with a loss delivers to the party with a gain a cash payment equal to the gain, and no shares are exchanged.

30





Classified in Equity (EITF 00-19)?Generally, equity if

(a) if contract must be share settled, OR

(b) if issuer controls form of settlement of contract.

1. If contingently exercisable, is the contingency appropriate?; AND


31

Other terms might provide for net-

CASH settlement!




Generally, equity if

(a) contract must be share settled, OR


Certain factors might be present that indicate that share settlement is not really w/in issuer’s control (para. 12-32)!

But the contract allows the

Company to share-settle it!?

32










33

BUT: If convertible instrument qualifies as CONVENTIONAL, those factors would not apply to an otherwise share-settlable contract (see EITF 05-2 for what qualifies as “conventional”).










34

BUT: If convertible instrument qualifies as CONVENTIONAL, those factors would not apply to an otherwise share-settlable contract (see EITF 05-2 for what qualifies as “conventional”).

Rarelyconventional!



Back to our example: does the conversion option qualify as equity under EITF 00-19?

No, physical onlyNet-Cash Settleable, by its terms?

N/A, otherwise not plain-vanilla

Net-Cash Settleable, by other terms?

Yes, qualifies for “conventional” convertible debt exception

Physical settlement w/in control?

Conversion option in plain-vanilla debt qualifies for equity classification under EITF 00-19.

35






6c: Net settleable?






Conversion option in plain-vanilla debt instrument does not require bifurcation from debt host.

36


Polling Question #5

What percentage of convertible instruments do you think qualify as “conventional?”

• Greater than 50%• 10% - 50%• Less than 10 %• Don’t know / not applicable


What We Didn’t Tell You…

• How do I win the lottery and retire and not have to deal with this stuff?

Come on, stop dreaming and get back to the real

world!

37



• How is the host contract determined for convertible preferred stock?

• How are conversion options in preferred stock evaluated?

• How is convertible preferred stock classified on the balance sheet? How is subsequently measured?

• When does a convertible instrument qualify as “conventional?”

• What are the factors in paragraphs 12-32 of EITF 00-19 that would indicate that share-settlement is not within the control of the issuer?

38



• What other terms present in a convertible instrument could cause an otherwise share-settleable conversion option to be net-cash settleable?

• What, when and how are beneficial conversion features evaluated?

• How are embedded puts/calls and contingent payments evaluated?

• How is EPS reported for non plain-vanilla convertibles (say, ones w/ participation rights or Instrument C)?

39


Polling Question #6

Have you found this webcast helpful?

• Yes• No


Polling Question #7

Which of the following would be helpful to you as topics for upcoming Convertibles Dbriefs?

• More about conversion options (“conventional” exception, factors in para. 12-32, potential net-cash settlement through other terms)• Convertible preferred stock (host contract, classification, subsequent measurement) • Beneficial conversion features• Other embedded features (puts/calls, contingent payments)• EPS• Don’t know / not applicable


Questions?

40


Contact info

[email protected] Glen

[email protected] Mueller

[email protected] Barker

[email protected] Comerford


Other Resources at www.Deloitte.com

•To locate webcasts, click on the DbriefsWebcast link at www.deloitte.com. You canfind archived webcasts located under“Webcast Archives; Financial Executives”.•To locate other publications, such asHeads Up and Accounting Roundup, visitthe “Assurance Newsletters” page onwww.deloitte.com.


Join us June 19th at 2 PM ET as our Financial Reporting group

presents:

EITF Roundup: Highlights of the June Meeting


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