Accounting for Convertible Instruments: An Overview

Transcription

1 Financial Reporting Presents: Accounting for Convertible Instruments: An Overview Rob Comerford James Barker Michael Mueller Sara Glen April 24, 2007

2 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

3 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

4 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

5 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

6 Overview Main Entry: con vert ible Pronunciation: kuh n-vur-tuh-buh l Function: adjective 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> Merriam-Webster s Online Dictionary 1

7 Overview Back then (1969) Convertible Debt Convertible into a fixed # of shares Standard antidilution provisions If-converted method 2

8 Overview Why the if-converted method is not popular Example Net income = $200, WASO = 200 $1,000 bond (coupon = 6%, conversion price = $10) Tax rate = 40%, Avg. Share Price = $7 Basic EPS = NI WASO = $ = $1.00 Dilutive even if conversion option is out of the money! Diluted EPS = NI + After-Tax Interest WASO + Assumed Shares = $ = $0.79 3

9 Overview Today (2007) Instrument C Contingently convertible Conversion spread settled in net shares, principal settled in cash Non-standard antidilution provisions Treasury stock method 4

10 Overview CONVERTIBLES Accounting Challenges Attractiveness of Convertibles Issuer: Low cost financing Investor: Upside potential # of Restatements Product Complexity CoCos, Instrument C, Instrument X, other features to minimize EPS/ economic dilution Accounting Complexity Too many form-driven rules in too many places in GAAP 5

11 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 financing transactions such as the issuance of convertible securities with beneficial conversion features and the issuance of equity instruments to third parties. In some cases the troubling attribute 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

12 Overview Restatements in 2005 and 2006: in the aggregate + debt/equity related 2,000 1,750 1,876 1,500 1,599 1,250 1, % % Single largest category! Information compiled from Audit Analytics, 2006 Financial Restatements A Six Year Comparison (Audit Analytics Briefing: February 2007) 7

13 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.

14 Overview Complex because 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 Initially and Subsequently! 8

15 Overview Hybrid, host, embedded feature Debt Host ( Host Contract ) Convertible Debt ( Hybrid Instrument ) Conversion Option ( Embedded Feature ) 9

16 Overview Hybrid, host, embedded feature Initial Accounting $950 $1,000 DR. Cash DR. Debt Discount $1,000 $50 CR. Derivative Liability $50 CR. Debt $1,000 $50 (Example ignores issue costs) Subsequent 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 10

17 Traditional Convertibles: APB 14 Let s start at the beginning 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 OK if adjusted for STANDARD antidilutive events 11

18 Traditional Convertibles: APB 14 The story about the frog prince + = + = 12

19 Traditional Convertibles: APB 14 I like the frog prince story Do we really need to talk about accounting? Accounting (APB 12, 14, 21) Treat convertible debt as straight debt. Present discount (premium) as a deduction from (addition to) face amount. Capitalize issue costs. EPS (FAS 128) Basic EPS: Exclude unless converted. Diluted EPS: Use if-converted method. Disclosures (FAS 129) Critical terms (maturity, conversion terms, effective interest rate, voting rights, participation rights, call prices and dates, etc.) Accrete discount (premium) and issue costs using interest method. 13

20 Traditional Convertibles: FAS 133 Conversion Option To B or not to B(ifurcate)? Bifurcation required? Derivative criteria met? Scope exception? 14

21 Traditional Convertibles: FAS 133 Does the conversion option in plain-vanilla debt require bifurcation from debt host? 12a: Not clearly and closely related to debt host? 12b: Hybrid = Not marked to market under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 15

22 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.

23 Traditional Convertibles: FAS 133 Does the conversion option in plain-vanilla debt require bifurcation from debt host? 12a: Not clearly and closely related to debt host? 12b: Hybrid = Not marked to market under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 16

24 Traditional Convertibles: FAS 133 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

25 Traditional Convertibles: FAS 133 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 on NASDAQ (avg. trading volume = 10,000 shares) At the issuance date, A s stock was trading at $7 per common share. 18

26 Traditional Convertibles: FAS a: 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

27 Traditional Convertibles: FAS 133 A issues $1,000 bond, convertible into 100 shares of A s actively-traded common stock Payoff $1,000 Conversion Option Host Conversion option is NOT clearly and closely related to NON- CONVERTIBLE host contract. $10 Stock Price 20

28 Traditional Convertibles: FAS b: Hybrid = not marked to market? On the road to bifurcation Current GAAP in APB 14 does not provide for FV remeasurement of convertible debt. But remember: FV election under FAS 155 or FAS

29 Traditional Convertibles: FAS 133 Does the conversion option in plain-vanilla debt require bifurcation from debt host? 12a: Not clearly and closely related to debt host? 12b: Hybrid = Not marked to market under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 22

30 Traditional Convertibles: FAS c: Conversion option = derivative? Elements of a Derivative 6a: Underlying? 6a: Notional? 6b: Small initial net investment? 6c: Net settleable? Element Present? Yes, market price of underlying shares of A s common stock Yes, # of shares of A s common stock into which debt can be converted Yes, FV of conversion option < initial FV of underlying shares, by more than a nominal amount See next slide On the road to bifurcation 23

31 Traditional Convertibles: FAS 133 Elements of a Derivative 6c: Net settleable: 9a: Can conversion option be explicitly net settled (=neither party must deliver an asset related to underlying and equal in quantity to notional)? 9b: Can conversion option be net settled via a market mechanism (e.g., an exchange)? 9c: Are underlying shares readily convertible to cash? Element Present? No, explicit gross settlement (A delivers the shares underlying the conversion option in exchange for debt instrument). No. Yes, A s stock is publicly traded and # of shares could be rapidly absorbed by market w/o significantly affecting the price. On the road to bifurcation 24

32 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.

33 Traditional Convertibles: FAS 133 Does the conversion option in plain-vanilla debt require bifurcation from debt host? 12a: Not clearly and closely related to debt host? 12b: Hybrid = Not marked to market under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 25

34 Traditional Convertibles: FAS 133 Help is on the way: The 11(a) scope exception Indexed to Issuer s Own Stock (EITF 01-6)? Classified in Equity (EITF 00-19)? Bifurca tion 26

35 Traditional Convertibles: FAS 133 Help is on the way: The 11(a) scope exception Indexed to Issuer s Own Stock (EITF 01-6)? Potential problem area for complex convertibles! 1. If contingently, exercisable, is the contingency appropriate?; AND 2. Once contingency has occurred, is the settlement value based solely on the issuer s stock price? 27

36 Traditional Convertibles: FAS 133 A issues $1,000 bond, convertible into 100 shares of A s actively traded common stock Payoff $1,000 Conversion Option Host Conversion option is indexed to A s common stock (settlement value is based solely on A s stock price). $10 Stock Price 28

37 Traditional Convertibles: FAS 133 Help is on the way: The 11(a) scope exception Indexed to Issuer s Own Stock (EITF 01-6)? 1. If contingently exercisable, is the contingency appropriate?; AND 2. Once contingency has occurred, is the settlement value based solely on the issuer s stock price? Classified in Equity (EITF 00-19)? What does this mean? 29

38 Traditional Convertibles: FAS 133 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

39 Traditional Convertibles: FAS 133 Help is on the way: The 11(a) scope exception Indexed to Issuer s Own Stock (EITF 01-6)? 1. If contingently exercisable, is the contingency appropriate?; AND 2. Once contingency has occurred, is the settlement value based solely on the issuer s stock price? 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. Other terms might provide for net- CASH settlement! 31

40 Traditional Convertibles: FAS 133 Classified in Equity (EITF 00-19)? Generally, equity if (a) contract must be share settled, OR (b) if issuer controls form of settlement of contract. But the contract allows the Company to share-settle it!? Certain factors might be present that indicate that share settlement is not really w/in issuer s control (para )! 32

41 Traditional Convertibles: FAS 133 Classified in Equity (EITF 00-19)? Generally, equity if (a) contract must be share settled, OR (b) if issuer controls form of settlement of contract. But the contract allows the Company to share-settle it!? Certain factors might be present that indicate that share settlement is not really w/in issuer s control (para )! 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 ). 33

42 Traditional Convertibles: FAS 133 Classified in Equity (EITF 00-19)? Generally, equity if (a) contract must be share settled, OR (b) if issuer controls form of settlement of contract. But the contract allows the Company to share-settle it!? Certain factors might be present that indicate that share settlement is not really w/in issuer s control (para )! 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 ). Rarely conventional! 34

43 Traditional Convertibles: FAS 133 Back to our example: does the conversion option qualify as equity under EITF 00-19? Net-Cash Settleable, by its terms? Net-Cash Settleable, by other terms? Physical settlement w/in control? No, physical only N/A, otherwise not plainvanilla Yes, qualifies for conventional convertible debt exception Conversion option in plain-vanilla debt qualifies for equity classification under EITF

44 Traditional Convertibles: FAS a: Not clearly and closely related to debt host? 12b: Hybrid = Not marked to market under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? Conversion option in plain-vanilla debt instrument does not require bifurcation from debt host. 36

45 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

46 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

47 What We Didn t Tell You 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 of EITF that would indicate that share-settlement is not within the control of the issuer? 38

48 What We Didn t Tell You What other terms present in a convertible instrument could cause an otherwise sharesettleable 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

49 Polling Question #6 Have you found this webcast helpful? Yes No

50 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 , 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

51 Questions? 40

52 Contact info Rob Comerford James Barker Michael Mueller Sara Glen

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