Accounting for Convertible Instruments: Puts, Calls and Contingent Payments

Transcription

1 Financial Reporting Presents: Accounting for Convertible Instruments: Puts, Calls and Contingent Payments Jim Johnson James Barker Adrian Mills Michael Mueller Magnus Orrell October 30, 2007

2 Agenda Flashback to Prior Convertibles Dbriefs FSP APB 14-a Put & Call Options Contingent Payment Features Form vs. Substance

3 Learning Objectives At the end of the webcast, participants should have an understanding of the following in convertible debt instruments: Embedded put and call options Embedded contingent payment features Certain form vs. substance issues

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 webcasts (see last slide) Seriously, try to have some fun with this stuff because, otherwise, you ll look like this guy

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

6 Flashback to Prior 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

7 Flashback to Prior 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

8 Flashback to Prior 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

9 Flashback to Prior 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

10 Proposed FSP APB 14-a Listen up! This is big news! Scope Convertible debt that may be cash settled upon conversion (e.g., Instrument C) Impact Separate recognition of debt and equity components Will increase interest expense due to debt discount recorded at inception Timing & Transition Comment period ended October 15th Proposed effective date: January 1, 2008 Retrospective application (no grandfathering) 6

11 Polling Question #1 Which of the previous webcasts did you attend? 1 st installment held on April 30 th only 2 nd installment held on July 31 st only Both 1 st and 2 nd installments I haven t attended any of the previous webcasts

12 MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ 7

13 Put & Call Options MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ Our focus in this section! 8

14 Put & Call Options Does the put/call option in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception? 11a doesn t apply to puts/calls in debt! EITF 01-6: Indexed to Issuer s Own Stock? EITF 00-19: Classified in Equity? 9

15 Put & Call Options 12a: When is a put/call option clearly and closely related to a debt host? Why important? If the put/call is NOT clearly and closely related to the debt host, it must be bifurcated Guidance in: DIG B16 (4-step sequence) 13 ( negative yield and double return tests) 10

16 Put & Call Options DIG B16 Flowchart Step 1 Y Step 2 N Y N Step 3 Step 4 N Y Y N Not C&CR Not C&CR Step 1: Step 2: Is Payoff Indexed (Not Par + Accrued Interest)? Indexed To Other Than Interest or Issuer s Credit? Step 3: Issued at Substantial Premium/Discount (10%)? Step 4: Contingently Exercisable? 11

17 Put & Call Options Example 1 Debt callable at par + % increase in S&P 500 Put & Call Options DIG B16 Flowchart Step 1 Y Y Step 2 N N Y Step 3 Step 4 N Y N Not C&CR Not C&CR Yes (equity index)! Step 1: Is Payoff Indexed (Not Par + Accrued Interest)? Step 2: Indexed To Other Than Interest or Issuer s Credit? Step 3: Issued at Substantial Premium/Discount (10%)? Step 4: Contingently Exercisable? N/A (doesn t impact analysis)! 12

18 Put & Call Options Example 2 Debt issued at 3% discount, callable after 3 years at par + PV of unpaid future interest Put & Call Options DIG B16 Flowchart Step 1 Y Y Step 2 N N Y Step 3 Step 4 N Y N Not C&CR Not C&CR Yes, but to interest! Step 1: Step 2: Is Payoff Indexed (Not Par + Accrued Interest)? Indexed To Other Than Interest or Issuer s Credit? Step 3: Issued at Substantial Premium/Discount (10%)? Step 4: Contingently Exercisable? No, discount = 3%! N/A 13

19 Put & Call Options Example 3 Debt issued at 12% discount, puttable at par if LIBOR changes by 100 basis points Put & Call Options DIG B16 Flowchart Step 1 Y Y Step 2 N N Y Step 3 Step 4 N Y N Not C&CR Not C&CR No, put price = par! Step 1: Step 2: Is Payoff Indexed (Not Par + Accrued Interest)? Indexed To Other Than Interest or Issuer s Credit? Step 3: Issued at Substantial Premium/Discount (10%)? Step 4: Contingently Exercisable? Yes, discount = 12%! Yes, puttable upon LIBOR 100 bps! 14

20 Put & Call Options Example 4 Debt issued at 3% discount, puttable at par upon change of control Put & Call Options DIG B16 Flowchart Step 1 Y Y Step 2 N N Y Step 3 Step 4 N Y N Not C&CR Not C&CR No, put price = par! Step 1: Step 2: Is Payoff Indexed (Not Par + Accrued Interest)? Indexed To Other Than Interest or Issuer s Credit? Step 3: Issued at Substantial Premium/Discount (10%)? Step 4: Contingently Exercisable? No, discount = 3%! N/A 15

21 Polling Question #2 XYZ issued $100 million in convertible debt at par. If the S&P 500 increases by at least 20%, the investor can put the debt for par plus the percentage increase in the S&P 500. Is the put option clearly and closely related to the debt ( 12a of FAS 133)? Yes No Don t know

22 Put & Call Options 13 Flowchart Y Step 1 Step 2 N Y N Not C&CR Not C&CR C&CR Step 1: Step 2: Negative Yield Test : Could the Investor Be Forced to Settle at Less than Substantially All of Initial Investment? Double Return Test : Could the Issuer Be Forced to Pay Both Twice the Initial Return & Twice the Market Return? 16

23 Put & Call Options Things to know about 13 13a: Negative Yield Test Look at undiscounted cash flows Substantially all = 90% or more Doesn t apply to investor puts (DIG B5) 13b: Double Return Test Doesn t apply to issuer calls (DIG B39) Applicable to both: Assess at inception or acquisition only Any possibility whatsoever (even if remote) Ignore changes in issuer s credit quality 17

24 Put & Call Options Previously, the DIG B16 analysis for examples 2 and 4 was Example Indexed Payoff? (Steps 1 + 2) Substantial Discount or Premium? (Step 3) Contingently Exercisable? (Step 4) Result 2 Debt issued at 3% discount, callable upon IPO at par + PV of unpaid future interest Yes (but to interest) No N/A Analyze further under 13 4 Debt issued at 3% discount, puttable at par upon a change of control No No N/A Analyze further under 13 Now let s apply 13 18

25 Put & Call Options Example 2 Debt issued at 3% discount, callable after 3 years at par + PV of unpaid future interest Put & Call Options 13 Flowchart Not C&CR Step 1: Step 2: Y Y Step 1 Step 2 N N Not C&CR C&CR Negative Yield Test : Could the Investor Be Forced to Settle at Less than Substantially All of Initial Investment? Double Return Test : Could the Issuer Be Forced to Pay Both Twice the Initial Return & Twice the Market Return? No, call price >= par! N/A (issuer call DIG B39)! 19

26 Put & Call Options Example 4 Debt issued at 3% discount, puttable at par upon change of control Put & Call Options 13 Flowchart Y Step 1 N Step 2 Y N Not C&CR Not C&CR C&CR N/A (investor put DIG B5)! Step 1: Step 2: Negative Yield Test : Could the Investor Be Forced to Settle at Less than Substantially All of Initial Investment? Double Return Test : Could the Issuer Be Forced to Pay Both Twice the Initial Return & Twice the Market Return? Yes, put allows for investor to achieve a substantially leveraged return (ignore probability)! 20

27 Put & Call Options In summary Put & Call Options Does the put/call option in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? Maybe No Yes Yes Yes Yes Whether put/call in debt instrument requires bifurcation will mainly depend on C&CR analysis under DIG B16 and possibly 13 Copyright 2007 Deloitte Development LLC. All rights reserved. 21

28 Put & Call Options MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ In this section, we focused on 22

29 Polling Question #3 ABC issues $100 million par value convertible debt for $97 million. The investor can put the convertible debt to ABC for par upon a change of control. Is the put option clearly and closely related to the debt ( 12a of FAS 133)? Yes No Don t know

30 Contingent Payment Features MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ Our focus in this section! 23

31 Contingent Payment Features Contingency If something happens Examples of Triggers Change of control IPO or lack thereof Delisting Non-timely filings w/ SEC Failure to pay P+I when due Payment I must transfer value that I otherwise would not have to transfer. Examples of Payments Increased interest rate or dividend rate Lump-sum payment (e.g., make-whole) 24

32 Contingent Payment Features Does the contingent payment feature in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 25

33 Contingent Payment Features 12a: Is the contingent payment feature clearly and closely related to the debt host? Answer: Typically, no. Contingent payment features are NOT clearly and closely related unless the contingency is tied to: Interest rate or interest rate index that passes 13 Inflation index (nonleveraged) Issuer s creditworthiness 26

34 Contingent Payment Features Does the contingent payment feature in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? No 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 27

35 Contingent Payment Features 12b: Is the hybrid instrument (i.e., convertible debt) marked to FV with changes in FV being reported in P/L under other GAAP? Answer: Generally, no. Current GAAP does not provide for FV remeasurement of convertible debt But remember: FV election under FAS 155 or FAS

36 Contingent Payment Features Does the contingent payment feature in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? No No 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? 29

37 Contingent Payment Features 12c: If freestanding, would contingent payment feature in convertible debt be a derivative subject to FAS 133? Answer: Yes. The contingent payment feature has an underlying (occurrence of an event) a payment provision small initial net investment explicit net settlement (one-way transfer of value) UNLESS: Contingency triggering payment provision is within issuer s control! 30

38 Contingent Payment Features In summary: Generally, contingent payments require bifurcation unless Contingent Payment Features Does the contingent payment feature in convertible debt require bifurcation from the host contract? 12a: Clearly and closely related to host contract? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? No No Yes Contingency tied to interest rates, issuer s credit or inflation 6a: Underlying, notional? 6b: Small initial net investment? 6c: Net settleable? Yes Yes Yes Contingency is within issuer s control 31

39 Contingent Payment Features MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ In this section, we focused on 32

40 Polling Question #4 If Company ABC does not file its 10-K with the SEC within 60 days after year-end, the interest rate on ABC s convertible debt will increase from 6% to 8%. Must this contingent payment feature be bifurcated under FAS 133? Yes No, the contingency triggering the increase in the interest rate is (a) clearly and closely related to the debt and/or (b) controlled by ABC. Don t know

41 Form vs. Substance MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ Our main focus in this section: Impact of put on conversion option! 33

42 Form vs. Substance Conversion may be stock-settled put option Convertible into shares worth fixed-dollar amount Put option may be cash-settled conversion: Puttable for cash equal to FV of shares underlying conversion option Some features may be combinations: Convertible at lesser of.. Puttable at greater of. 34

43 Form vs. Substance Don t be ed by FV put option! Conversion option that is settled in shares (fixed #) Put option that is settled in cash equal to FV of shares underlying conversion option = (Economically Equivalent) Conversion option that can be settled at investor s option in: shares (fixed #), or cash Explicit net settlement! Doesn t qualify as equity under 11a! 35

44 Form vs. Substance Don t be ed by greater-of put option! Conversion option that is settled in shares (fixed #) Conversion option that can be settled at investor s option in: Put option that is settled in cash equal to greater of (i) FV of shares underlying conversion option or (ii) par value of debt = (Economically Equivalent) shares (fixed #), or cash Put option that is settled in cash equal to par value of debt Separate analysis under 12! Explicit net settlement! Doesn t qualify as equity under 11a! 36

45 Form vs. Substance Let s look at an example XYZ issues convertible debt: Convertible into 100 shares of XYZ s common stock Puttable after 3 years of issuance for greater of (i) par value or (ii) FV of shares underlying conversion option Question: Does the conversion option require bifurcation? 37

46 Form vs. Substance Example (continued) Form vs. Substance Does the conversion option in a convertible instrument require bifurcation from the host contract? Answer: Yes. By its terms, the conversion option can only be physically settled (shares for debt instrument). 12a: Clearly and closely related to debt host? 12b: Hybrid = Marked to FV under other GAAP? 12c: If freestanding, derivative? 6a: Underlying; notional or payment provision? 6b: Small initial net investment? 6c: Net settleable? 11a: Qualify for Scope Exception (consider EITFs and 01-6)? No No Yes Yes Yes Yes No BUT: The greater-of put option allows the investor to receive cash equal to the FV of the underlying shares and thus net-cash settle the conversion option. Bifurcate! The conversion option does not qualify as equity under EITF and hence not for 11a scope exception! 38

47 Form vs. Substance Now The 12c analysis becomes more complex when FV put or greater-of put can only be contingently exercised: If contingency is within issuer s control, OR If convertible instrument qualifies as conventional AND contingency is one of those in of EITF 00-19, contingent put will not taint conversion option; otherwise it will 39

48 Form vs. Substance MONSTER MASH, INC. $100,000,000 AGGREGATE PRINCIPAL 4.25% REDEEMABLE CONVERTIBLE SUBORDINATED DEBENTURES DUE 2016 (ISSUED AT 3% DISCOUNT) Convertible by investor into Monster Mash, Inc. common stock at any time at $40 per share Callable by Monster Mash, Inc., after 3 years of issuance for principal and accrued interest Puttable by investor for principal and accrued interest upon change of control Puttable by investor after 3 years of issuance for greater of (i) principal and accrued interest or (ii) fair value of common shares underlying conversion option Interest rate on debt increases by 150 basis points if Monster Mash, Inc. s common stock is delisted from NASDAQ In this section, we focused on 40

49 Polling Question #5 ABC issues convertible debt that is puttable upon a change of control for the FV of the shares underlying the conversion option. The contingent put option could result in the conversion option having to be bifurcated under FAS 133. True or false? True False Don t know

50 What s Left Convertible Preferred Stock: How are embedded features (i.e., conversion option, put/call options, and contingent payment features) in preferred stock evaluated under FAS 133? How is convertible preferred stock classified on the balance sheet? How is it initially and 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)? 41

51 Polling Question #6 Would you be interested in future Dbriefs on other Liability & Equity topics (for example, accounting for accelerated share repurchases, overview of FAS 150, etc.)? Yes No

52 Questions? 42

53 Join us November 9 th at 2 PM EST as our Financial Reportingseries presents: Special Edition: The State of the Credit Market and Its Impact on Financial Reporting

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55 Contact Information James Barker Adrian Mills Michael Mueller Magnus Orrell

56 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

57 Other Resources Links Accounting for Convertible Instruments: An Overview (1 st Installment of Series) Accounting for Convertible Instruments (2 nd Installment of Series) 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 n/prereg/register.jsp?clientid=404&event id=58225&sessionid=1&key=05162f673 98C825D443D77A3000EA31D 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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