Accounting for Convertible Instruments

Transcription

1 Financial Reporting Presents: Accounting for Convertible Instruments James Barker Michael Mueller Mark Bolton Magnus Orrell July 31, 2007

2 Agenda Flashback to 1 st Convertibles Dbriefs Let s Meet Ms. Host Let s Meet Mr. Conventional Let s Meet Mr. Not-So Conventional What s left

3 Learning Objectives At the end of the webcast, participants should have an understanding of how the host contract of a convertible instrument is determined when a convertible instrument qualifies as conventional impact on EITF analysis the 8 factors in paragraphs of EITF

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. Remember, the Convertibles Dbriefs are designed to build on each other. If you haven t yet had the opportunity to view the previous webcast, you are out of luck just joking, you can retrieve the webcast (see last slide). Seriously, try to have some fun with this stuff because, otherwise, you ll look like this guy

5 Polling Question #1 Did you attend the previous webcast? Yes No

6 Flashback to 1 st Convertibles Dbriefs Back then (1969) Convertible Debt Convertible into a fixed # of shares Standard antidilution provisions If-converted method 1

7 Flashback to 1 st Convertibles Dbriefs Today (2007) Instrument C Contingently convertible Conversion spread settled in net shares, principal settled in cash Non-standard antidilution provisions Treasury stock method 2

8 Flashback to 1 st Convertibles Dbriefs 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 3

9 Flashback to 1 st Convertibles Dbriefs 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! 4

10 Flashback to 1 st Convertibles Dbriefs 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) 5

11 Flashback to 1 st Convertibles Dbriefs Does the conversion option in a convertible instrument require bifurcation from the host contract? 12a: Not clearly and closely related to host contract? 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? 6

12 Flashback to 1 st Convertibles Dbriefs Does the conversion option in a convertible instrument require bifurcation from the host contract? 12a: Not clearly and closely related to host contract? 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? Today s focus EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 7

13 Polling Question #2 Test question: What are the accounting implications of applying SFAS 133 to the conversion option? Income statement volatility for the issuer Higher interest expense on the debt Valuation challenges All of the above Don't know/not applicable

14 Let s Meet Ms. Host Before we say hi to Ms. Host, let s go back to the host discussion in 1 st Dbriefs 8

15 Let s Meet Ms. Host Previously Debt/Equity Host ( Host Contract ) Convertible Debt/Preferred Stock ( Hybrid Instrument ) Conversion Option ( Embedded Feature ) 9

16 Let s Meet Ms. Host Previously (continued) 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 Let s Meet Ms. Host Guiding principle: Does the host contract encompass a residual interest in the issuing entity (para. 60 of FAS 133)? Yes No Equity Host Debt Host EITF Topic D-109: Consider ALL substantive terms of the convertible! 11

18 Let s Meet Ms. Host Equity Host Debt Host Cumulative participating perpetual preferred stock Debt instrument Cumulative fixedrate preferred stock with mandatory redemption feature 12

19 Let s Meet Ms. Host Equity Host Cumulative participating perpetual preferred stock Impact of embedding a fixed-price put option? Impact of mandatory redemption at FV? Debt Host Debt instrument Cumulative fixedrate preferred stock with mandatory redemption feature 13

20 Let s Meet Ms. Host Example #1 A issues perpetual preferred shares: liquidation preference of $1,000 per share dividends of 6% per annum convertible into 100 shares of A s common stock puttable by investor for cash of $1,000 per share, plus accrued dividends. Question: When evaluating the conversion option, what is the host contract (debt or equity)? 14

21 Let s Meet Ms. Host Example #1 (continued) Terms of Convertible No creditor rights Seniority in liquidation Stated dividend Conversion option (fixed # of shares) Put option (fixed price) Equity-Like Debt-Like Ignore embedded feature that is being evaluated for bifurcation Seems like a debt host. Let s look at it graphically 15

22 Let s Meet Ms. Host Example #1 (continued): Payoff for HYBRID Payoff Upside potential like residual interest holder $1,000 Downside protection like a debt holder $10 Stock Price 16

23 Let s Meet Ms. Host Example #1 (continued): Payoff for HOST Payoff $1,000 Downside protection like a debt holder $10 Stock Price 17

24 Let s Meet Ms. Host Example #1 (continued) A issues perpetual preferred shares: liquidation preference of $1,000 per share dividends of 6% per annum convertible into 100 shares of A s common stock puttable by investor for cash of $1,000 per share, plus accrued dividends. Answer: DEBT HOST as embedded put at a fixed $ amount provides for downside protection, which is more debt-like. 18

25 Let s Meet Ms. Host Example #2 A issues perpetual preferred shares: liquidation preference of $1,000 per share dividends of 6% per annum convertible into 100 shares of A s common stock puttable by investor for cash of $1,000 per share, plus accrued dividends. Question: When evaluating the put option, what is the host contract (debt or equity)? Let s say hi to Ms. Host! 19

26 Let s Meet Ms. Host Example #2 (continued) Terms of Convertible No creditor rights Seniority in liquidation Stated dividend Conversion option (fixed # of shares) Put option (fixed price) Equity-Like Debt-Like Ignore embedded feature that is being evaluated for bifurcation 20

27 Let s Meet Ms. Host Example #2 (continued): Payoff for HYBRID Payoff Upside potential like residual interest holder $1,000 Downside protection like a debt holder $10 Stock Price 21

28 Let s Meet Ms. Host Example #2 (continued): Payoff for HOST Payoff Upside potential like residual interest holder $1,000 No principal protection like a debt holder $10 Stock Price 22

29 Let s Meet Ms. Host Example #2 (continued) A issues perpetual preferred shares: liquidation preference of $1,000 per share dividends of 6% per annum convertible into 100 shares of A s common stock puttable by investor for cash of $1,000 per share, plus accrued dividends. Answer: EQUITY HOST as absent the fixed-price put, the economic profile of the preferred stock is more akin to that of a residual interest holder. 23

30 Let s Meet Ms. Host Chama Chama Chama Chameleon When evaluating the conversion option When evaluating the put option Debt Host Hybrid Equity Host Hybrid Conversion Option Put Option 24

31 Let s Meet Ms. Host To be clear: The Chameleon host approach is one of the acceptable approaches in EITF Topic D-109. Remember: Consider all substantive terms of the convertible (absent the embedded feature being evaluated for bifurcation)! The clean-host approach is no longer acceptable under EITF Topic D

32 Polling Question #3 Test Question - Fill in the missing word: The Chameleon host approach considers all substantive terms of a convertible, the embedded feature that is being evaluated for bifurcation under FAS 133. Including Excluding Don t know

33 Let s Meet Mr. Conventional Let s see why he is so popular 26

34 Let s Meet Mr. Conventional Does the conversion option in a convertible instrument require bifurcation from host contract? 12a: Not clearly and closely related to host contract? 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? 27

35 Let s Meet Mr. Conventional 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. 28

36 Let s Meet Mr. Conventional Example: Settlement Methods Assume: Entity A issues $1,000 of debt at par. Debt is convertible into 100 shares of Entity A common stock at a strike price of $10/shr. Entity A s stock price rises to $15/shr. Entity B, the holder of the conversion option, exercises that option 29

37 Let s Meet Mr. Conventional Physical Settlement: B pays A $1,000 (100 $10/shr) A issues 100 shares, having a fair value of $1,500, to B Net Share Settlement: B has recognized an economic gain of $500 on the contract A issues of its shares to B ($500/$15 per share) Net Cash Settlement: A makes a cash payment of $500 to B 30

38 Let s Meet Mr. Conventional Previously 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. 31

39 Let s Meet Mr. Conventional Previously 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

40 Let s Meet Mr. Conventional Previously 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

41 Let s Meet Mr. Conventional General Overview of EITFs and 05-2: Conventional if Upon conversion, holder receives entire proceeds as a fixed number of shares or equivalent cash (at option of issuer) Ability to exercise based upon passage of time or contingent event (incl. CoCo s) OK if number of shares could change due to standard anti-dilution provisions 34

42 Let s Meet Mr. Conventional Also conventional - convertible preferred stock that: Has a mandatory redemption date, AND Is more akin to debt than equity consider: Creditor rights Dividend rights Voting rights Conversion rights Redemption provisions 35

43 Let s Meet Mr. Conventional Examples of Adjustments to Conversion Price Antidilution Provision Subdivision (stock split, stock dividend) Combination (reverse stock split) of outstanding common shares Issuance of common shares at a lower price than the conversion price in effect immediately prior to such issuance Recurring quarterly cash dividend to all common shareholders Recapitalization through a large nonrecurring cash dividend Standard/ Nonstandard? Standard Nonstandard Nonstandard Standard 36

44 Let s Meet Mr. Not-So Conventional Let s see why he loses the popularity contest against Mr. Conventional 37

45 Let s Meet Mr. Not-So Conventional Say, a debt instrument contains a conversion option that, by its terms, can only be share-settled. 1 4 If any of the factors in para are present, EITF presumes the issuer is forced to net-cash settle the conversion option, resulting in liability classification. 2 Say, convertible debt doesn t qualify as conventional under EITF Now must apply strict factors in para of EITF to conversion option. Conversion option doesn t qualify for 11a scope exception in FAS 133 and must be bifurcated as a separate derivative (assuming shares are readily convertible to cash). 3 38

46 Polling Question #4 Test question: Instrument C qualifies as conventional convertible debt. (Reminder: Instrument C requires cash settlement for the accreted value of the debt and permits the issuer to settle the conversion spread in either cash or shares.) True False Don t Know/Not Applicable

47 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Contract must permit settlement in UNREGISTERED shares. 2. Company must have enough authorized shares to settle the contract. 3. Contract must cap # of shares to be delivered. 4. No cash payments if Company does not timely file with SEC. 5. Contract does not contain cash-settled make-whole provisions. 6. Requirement to net-cash settle only if underlying shareholders also receive cash. 7. Contract does not give counterparty rights senior to the rights of underlying shareholders. 8. No requirement to post collateral. 39

48 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #1: Contract must permit settlement in UNREGISTERED shares. OK if contract requires delivery of Registered shares if registered at inception AND no further timely filing/registration requirements Unregistered shares in a private placement absent a failed registration in prior 6 months, or a unreasonable discount from value of corresponding registered shares 40

49 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #1: Contract must permit settlement in UNREGISTERED shares. (continued) If contract is silent, don t assume settlement in unregistered shares (matter of contract terms AND Federal Securities Law see Stephanie Hunsaker s speech at 2006 AICPA Conference) OK if prospectus explicitly states that if the issuer cannot deliver registered shares, non-settlement is an acceptable alternative 41

50 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #2: Company must have enough authorized shares to settle the contract. Consider # of shares to be delivered under other outstanding commitments in making this assessment If this criterion is failed, consider whether other instruments no longer qualify for equity classification (Todd Hardiman s speech at 2005 AICPA Conference) 42

51 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #3: Contract must cap # of shares to be delivered. Compare cap to available authorized shares (i.e., after considering # of shares to be delivered under other outstanding commitments, including makewhole provisions) Consider whether Company has obligation to settle contract value in excess of cap OK if Company can sharesettle excess obligation when authorized shares become available 43

52 Polling Question #5 Is Mr. Conventional looking better to you? Yes No Don t Know/Not Applicable

53 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #4: No cash payments if Company does not timely file with SEC. Factor #5: Contract does not contain cashsettled make-whole provisions. OK if make-whole is net-share settled and maximum # of shares to be delivered is fixed and less than available authorized shares (again, after considering # of shares to be delivered under other outstanding commitments) 44

54 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #6: Requirement to net-cash settle only if underlying shareholders also receive cash. OK (i.e., contract would still be considered to be indexed to stock of purchaser) if, upon change-in control, contract holder and shareholders all were to receive the same stock of acquirer Factor #7: Contract does not give counterparty rights senior to the rights of underlying shareholders. 45

55 Let s Meet Mr. Not-So Conventional Finally, the factors in para of EITF Factor #8: No requirement to post collateral. OK if issuer posts shares underlying the contract (limited to maximum # of shares that could be delivered) 46

56 Let s Meet Mr. Not-So Conventional Example On 1/1/07, ABC issues $75 million in notes: Convertible into 7.5 million ABC common shares Notes are not conventional under EITF ABC has 12 million authorized shares available (after considering share commitments from other outstanding contracts). OK under EITF at inception (12 million authorized shares > 7.5 million shares underlying conversion option). 47

57 Let s Meet Mr. Not-So Conventional Example (continued) On 2/1/07, ABC issues 9 million common shares. Question: What impact, if any, does the stock offering on 2/1/07 have on the evaluation of whether the embedded conversion option qualifies for the 11a scope exception in FAS 133? 48

58 Let s Meet Mr. Not-So Conventional Example (continued) # of authorized shares available # of shares issued in seasoned offering # of authorized shares remaining # of shares underlying conversion option # of excess underlying shares translated in aggregate face value of notes 12,000,000 9,000,000 3,000,000 7,500,000 4,500,000 $45,000,000 Answer: As of 2/1/07, conversion option embedded in $45 million of notes would no longer qualify for the 11(a) scope exception in FAS 133 (fails Factor #2 in EITF 00-19). 49

59 The Contest Now we know why Mr. Conventional is so popular Being conventional involves less maintenance in accounting terms, less work because: Don t have to analyze factors in para of EITF Don t need a law degree to figure out whether issuer can settle in unregistered shares 50

60 Polling Question #6 Test question: A conversion option is net-cash settleable upon a change of control. Equity or liability under EITF 00-19? Liability Equity Not enough facts Don t know

61 Recap of Who We Met Today Does the conversion option in a convertible instrument require bifurcation from the host contract? 12a: Not clearly and closely related to host contract? 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? Today s focus EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 51

62 What s left Form vs. Substance: When is redemption akin to cashsettled conversion? When is conversion akin to stocksettled redemption? Other Embeddeds: How are embedded puts/calls and contingent payments evaluated? Classification and Measurement: How is convertible preferred stock classified on the balance sheet? How is it subsequently measured? BCFs: What, when and how are beneficial conversion features evaluated? EPS: How is EPS reported for non-traditional convertibles (say, ones with participation rights or Instrument C)? 52

63 Questions? 53

64 Thank you for joining today s webcast. To request CPE credit, click the link below.

65 Contact info James Barker Michael Mueller Mark Bolton Magnus Orrell

66 Other Resources at To locate webcasts, click on the Dbriefs Webcast link at You can find archived webcasts located under Webcast Archives; Financial Executives. To locate other publications, such as Heads Up and Accounting Roundup, visit the Assurance Newsletters page on

67 Other Resources Links Accounting for Convertible Instruments: An Overview (1 st Installment of Series) Speech by SEC Staff - Stephanie Hunsaker Presentation by SEC Staff Todd Hardiman (beginning on page 88) AICPA Convertible Debt, Convertible Preferred Shares, Warrants, and Other Equity-Related Financial Instruments Working Draft n/prereg/register.jsp?clientid=404&event id=40186&sessionid=1&key= c AEFC08D54E33EA29BA1A5C5C pch121206slh.htm jl.pdf urces/accounting+and+auditing/account ing+standards/working+draft+of+conve rtible+debt+convertible+preferred+shar es+warrants+and+other+equi.htm

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