Board Meeting Handout Financial Instruments: Liabilities and Equity May 5, 2004

Transcription

1 Board Meeting Handout Financial Instruments: Liabilities and Equity May 5, 2004 At its March 3, 2004 education session, the Board discussed various bifurcation methods for financial instruments. The Board requested that the staff further research one of those approaches, the Reassessed Expected Outcomes (REO) Approach a unified method for determining classification, unit of accounting, measurement, and EPS for financial instruments involving an issuer s shares. At today s meeting, the staff will present to the Board the results of that research into the REO Approach. The meeting will be informational, and no Board decisions are expected. The presentation will focus on the following topics: 1. Overview of the REO Approach 2. Examples REO method details and comparisons to other approaches and economically similar instruments 3. Examples REO applied to other instruments 4. Summary of illustrated advantages 5. Issues, ramifications, and challenges 6. Other possible ways of applying REO 7. Timing and plans to deliberate REO. Copies of the staff s PowerPoint presentation slides, and related appendixes, are available in a separate attachment. The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 May 5, 2004 Board Meeting Handout Appendixes 1 3 and note to appendixes attached Reassessed Expected Outcomes Approach Financial Instruments: Liabilities and Equity Project

3 Disclaimer The views expressed in this presentation are those of the staff and do not represent positions of the FASB. Positions of the FASB are arrived at only after extensive due process and deliberations. Note: Some examples in this presentation may have minor rounding differences. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 2

4 Presentation Agenda Overview of Reassessed Expected Outcomes (REO) approach Examples REO method details and comparison to other approaches and economically similar instruments Examples REO applied to other instruments Summary of illustrated advantages Issues, ramifications, and challenges Other possible ways of applying REO Timing and plan to deliberate REO Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 3

5 Overview of REO Approach Principles and Objectives Results Advantages

6 Principles and Objectives Account for equity-linked financial instruments based on the modern theory investors use to price options and contingent claims (which the Board cited in Concepts Statement 7). Represent economic substance by decomposing equitylinked instruments into base components: Equity (common stock). Liabilities (straight debt). Assets. How? By analyzing the expected future flows of cash and other economic resources at each reporting date. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 5

7 Principles and Objectives (cont.) Classify a financial instrument component as equity if and only if it conveys an ownership relationship the expected payment varies directly with the issuer s share price no matter what the form of settlement Provide consistent accounting and earnings per share (EPS) treatment among economically similar transactions to remove incentives for accounting arbitrage Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 6

8 Results Focus is on expected inflows or outflows of economic resources (cash or shares), not on control over right or obligation The allocation between debt and equity components is reassessed over time, as changes in market prices change the probability that the flow of economic resources will have a fixed value or will vary with the issuer s stock price To be consistent with current historical cost accounting for straight debt, allocations change only as a function of the stock price and time (the two variables that dominate valuation) Balance sheet and income statement presentation is based on the current economics of equity-linked transactions We may eliminate the need to distinguish basic and diluted EPS, and improve on both of them Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 7

9 Internal consistency Advantages Can be implemented separately for each transaction, and a single model can serve for the life of the contract No need to define a unit of accounting (however, linkage issues may still be relevant for presentation purposes) Same results, regardless of how instruments are combined or the form of settlement (including EPS) Reclassification of debt that converts to equity occurs smoothly over time as the probability of conversion increases, rather than abruptly at conversion Eliminates the ability to defer balance sheet and income statement recognition of major changes in economics until the settlement of an instrument Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 8

10 Illustrative Examples What Is It? How Does It Compare with Other Approaches? Does It Handle Other Instruments?

11 REO What Is It? How Does It Compare with Other Approaches? Method Details Examples Compared to Other Approaches, for Economically Similar Instruments

12 REO Method Details It all begins with contingent claims pricing theory, centered around a closed form equation, such as the seminal Black-Scholes-Merton model published in 1973, typically expressed something like this: Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 11

13 REO Method Details Expected outcomes of instruments with both debt and equity possibilities can be modeled using modern contingent claims pricing techniques. Many instruments can be modeled using closed-form equations that are developments of the seminal Black-Scholes-Merton equation for call options held. Restated in words, that equation is: Option s total value = Stock price * N(d 1 ) Discounted Strike Price * N(d 2 ) where: N is the cumulative standard Normal distribution the bell curve d 1 = logarithm of (stock price / strike price) + (interest rate + variance/2) time stock s standard deviation * square root of time d 2 = d 1 stock s standard deviation * square root of time and the strike price is discounted at the risk-free rate. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 12

14 REO Method Details* Black-Scholes-Merton is further developed for the REO method by substituting the issuer s straight debt rate for the risk-free rate, and incorporating expected dividends on the stock and modified to cover the particular security for example, for convertible debt, the big difference from the written call is that the investor has effectively prepaid the strike price, so the second term of the valuation equation is positive rather than negative Convertible Total Value = Stock Component + Accreted Principal Debt Component Convertible Stock Component = Convertible Parity Delta * Convertible Parity Convertible Parity Delta = PV Factor Discounting to Maturity at Dividend Yield * Convertible Call N(d 1 ) Convertible Parity = Conversion Ratio x Stock Price Convertible Accreted Principal Debt Component = PV of Convertible Accreted Principal Payment * Convertible Call [1 N(d 2 )] Convertible Stock Delta = Number of Shares for EPS Purposes = Conversion Ratio x Convertible Parity Delta *Appendix 3 and note to Appendixes provides more details. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 13

15 REO Method Details Convertible Debt Inputs for key variables Remaining Years to Maturity (t) Stock Price (S) $ 100 $ 150 $ 150 $ 150 $ 150 $ 150 Annual Volatility (s) % % % % % % Annual Semiannual Pay Straight Debt Rate 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% Convertible Accreted Principal at Maturity $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 Conversion Ratio Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 14

16 REO Method Details Convertible Debt* Day 1, Stock =$100 Convertible Total Value [912.48] = Convertible Stock Component [480.62] = 60.08% x 800 Convertible Parity Delta [60.08%] = 100% x 60.08% PV Factor Discounting to Maturity at Dividend Yield [100%] = EXP (0% x 5 yr) Convertible Call N 1 [60.08%] = Cum. Std. Normal Distr. of d 1 [.2553] Convertible Parity [800] = Conversion ratio [8] * Stock Price [100] Convertible Accreted Principal Debt Component [431.86] = * ( %) PV of Convertible Accreted Principal Payment Convertible Call N 2 [44.72%] = Cum. Std. Normal Distr. of d 2 [-.1328] Convertible Stock Delta [4.81] = 8 x 60.08% *See Appendixes 1, 3 and note to appendixes for more details. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 15

17 REO Method Details Convertible Debt* End of Year 1, Stock =$150 Same method as Day 1, using current share price and time to expiration, except that the stock component is not taken from the model, but rather, to be compatible with historical proceeds accounting for straight debt, is the residual after subtracting the debt component from original proceeds and adding interest: Convertible Original Total Value [912.48] = Convertible Stock Component [787.47] = Convertible Parity Delta [89.76%] = 100% x 89.76% PV Factor Discounting to Maturity at Dividend Yield [100%] = EXP (0% x 4 yr) Convertible Call N 1 [89.76%] = Cum. Std. Normal Distr. of d 1 [1.2678] Convertible Parity [800] = Conversion ratio [8] * Stock Price [100] Convertible Accreted Principal Debt Component [146.61] = x ( %) PV of Convertible Accreted Principal Payment Convertible Call N 2 [82.14%] = Cum. Std. Normal Distr. of d 2 [.9206] Interest accrual [21.59] = Straight Debt Rate (5%) x Debt Component Day 1 (431.86) Convertible Stock Delta [7.18] = 8 x 89.76% *See Appendixes 2, 3 and note to appendixes for more details. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 16

18 Three Securities Same Outcome* Convertible Debt Written Call Option Plus Straight Debt Puttable Stock (or Put Option Written on Issued Shares) Sales pitch to investors: Equity participation on the upside, plus downside protection Sales pitch to issuers: Good economics, even better accounting *For the following slides presenting numerical examples, see Appendixes 1 3 and note to Appendixes for more details. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 17

19 Convertible Debt The Gory Details Numerical examples of the Reassessed Expected Outcomes (REO) Model - Accounting and EPS effects Convertible bond Reassessed Expected Outcomes Current GAAP Share price Cash Asset Debt Equity (paid in capital) Interest expense (income) REO Income REO Shares EPS Income Shares Basic EPS Diluted EPS Day One (431.86) (480.62) (1,000.00) (1,000.00) Year 1 Accrue interest - (21.59) Reassess split (306.85) Ending Balance (146.61) (787.47) (978.41) (983.13) Year 2 Accrue interest - (7.33) Reassess split 6.19 (6.19) Ending Balance (147.75) (793.66) (992.67) (982.82) Year 3 Accrue interest - (7.39) Reassess split (16.24) Ending Balance (138.89) (809.90) (992.61) (982.50) Year 4 Accrue interest - (6.94) Reassess split (44.94) Ending Balance (100.89) (854.84) (993.06) (982.18) Year 5 Accrue interest - (5.04) Reassess split (105.94) Exercise/payoff - - Ending Balance (960.78) (994.96) (981.85) Year 6 5% Reflect new shares Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 18 Ending Balance (960.78) (1,000.00) (1,000.00)

20 Written call + Straight Debt Numerical examples of the Reassessed Expected Outcomes (REO) Model - Accounting and EPS effects Straight Debt Plus Call Option Written Reassessed Expected Outcomes Current GAAP Sh. Pric e Cash Asset Debt Equity (paid in capital) Int. Exp. (inc.) REO Income REO Shares EPS Income Shares Day One Issue debt (781.20) Write option (131.28) Assess split (349.33) Beginning Bal (431.86) (480.62) (1,000.00) (1,000.00) Basic EPS Diluted EPS Year 1 Accrue interest - (21.59) Reassess split (306.85) Ending Balanc (146.61) (787.47) (978.41) (960.94) Year 2 Accrue interest - (7.33) Reassess split (6.19) Ending Balanc (147.75) (793.66) (992.67) (958.99) Year 3 Accrue interest - (7.39) Reassess split (16.24) Ending Balanc (138.89) (809.90) (992.61) (956.94) Year 4 Accrue interest - (6.94) Reassess split (44.94) Ending Balanc (100.89) (854.84) (993.06) (954.78) Year 5 Accrue interest - (5.04) Reassess split (105.94) Exercise option 1, (1,000.00) Payoff debt (1,000.00) 1, Ending Balanc (960.78) (994.96) (952.52) Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 19

21 Puttable Stock/Written Put Option Numerical examples of the Reassessed Expected Outcomes (REO) Model - Accounting and EPS effects Put option written Reassessed Expected Outcomes Current GAAP Equity (paid in capital) Interest expense (income) Share price Cash Asset Debt REO Income REO Shares EPS Income Shares Day One: Issue shares Write option Combine Allocate (431.86) Basic EPS Diluted EPS Day One (431.86) (480.62) (1,000.00) (1,000.00) Year 1 Accrue interest - (21.59) Reassess split (306.85) (0.82) - Put MTMarket (88.80) Ending Balance (146.61) (787.47) (978.41) (1,088.80) Year 2 Accrue interest - (7.33) Reassess split 6.19 (6.19) (0.85) - Put MTMarket (2.82) Ending Balance (147.75) (793.66) (992.67) (1,002.82) Year 3 Accrue interest - (7.39) Reassess split (16.24) (0.82) - Put MTMarket (4.89) Ending Balance (138.89) (809.90) (992.61) (1,004.89) Year 4 Accrue interest - (6.94) Reassess split (44.94) (0.62) - Put MTMarket (8.16) Ending Balance (100.89) (854.84) (993.06) (1,008.16) Year 5 Accrue interest - (5.04) Reassess split (105.94) - - Put MTMarket (7.82) Exercise/payoff - - Ending Balance (960.78) (994.96) (1,007.82) Year 6 5% Reflect new shares - - Ending Balance (960.78) (1,000.00) (1,000.00) Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 20

22 Convertible Debt (CD) Compared to Written Call (WC) + Straight Debt (SD) Amount at End of Yr 1 (in the money, stock $150) Current GAAP or Fundamental Components, IAS 32R, or Minimum Unreassessed Expected Reassessed Expected Outcomes Pure Equity Obligation Outcomes REO CD WC+SD CD WC+SD CD WC+SD CD WC+SD Liability Equity Interest Earnings EPS No. Shares EPS EPS (diluted) Straight debt rate = 5%; CD yield 1.84%; Earnings before interest = $1,000; Convertible into 8 shares; $1,000 face value; Strike $125 Note that for REO, the ending delta number of shares was used instead of a weighted average. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 21

23 Amount at End of Yr 1 (stock $150) Puttable Stock (PS)/Written Put (WP) Compared to Convertible Debt (CD) Current GAAP or Pure Equity (Current GAAP PS is temporary equity) (Slide 1 of 2) Fundamental Components Minimum Obligation (WP same as current GAAP) PS WP CD PS or WP CD PS CD Liability Equity Expense (88.80) (88.80) Earnings EPS No.Shares EPS EPS (diluted) Straight debt rate = 5%; CD yield 1.84%; Earnings before interest/gain = $1,000; Notional 8 shares; Written put includes underlying shares; Strike $125 Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 22

24 Puttable Stock (PS)/Written Put (WP) and Convertible Debt (CD) Comparison (Slide 2 of 2) Amount at End of Yr 1 (stock $150) Unreassessed Expected Outcomes IAS 32R PS WP CD PS or WP CD PS or WP CD Liability Equity Expense (88.80) Earnings EPS No.Shares EPS EPS (diluted) Straight debt rate = 5%; CD yield 1.84%; Earnings before interest/gain = $1,000; Notional 8 shares; Written put includes underlying shares; Strike $125 Note: For written puts under IAS 32R, there are mixed views about the discount rate to be used and the exclusion of shares for EPS. Physical settlement is required. Reassessed Expected Outcomes REO Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 23

25 REO How Does It Handle Other Instruments? *For the following slides presenting numerical examples, see Appendixes 1 3 and note to Appendixes for more details.

26 Forward Contracts and Separate Options Written calls might result in assets(!?!) even though the issuer has no right to control Purchased calls result in liabilities even though the issuer has no obligation Forward purchase contracts are accounted for the same as in Statement 150; separate or combined options are accounted for that same way, differently from Statement 150 Stock that is puttable and callable on same date at same strike price is accounted for the same as mandatorily redeemable stock Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 25

27 Forward Purchase (FP) Compared to Written Put (WP) + Purchased Call (PC) Amount at End of Yr 1 (stock $150) Current GAAP (WP+PC are separate contracts; WP/PC is one contract) Fundamental Components, Pure Equity, Minimum Obligation, and Unreassessed Expected Outcomes IAS 32R FP WP+PC WP/PC FP WP+PC FP WP+PC FP WP+PC Liability(Asset) (379.25) (379.25) (379.25) Equity (131.28) Expense (88.80) (360.45) (360.45) (360.45) Earnings EPS No.Shares EPS EPS (final) Straight debt rate = 5%; Earnings before interest/gain = $1,000; Notional 8 shares; Physical settlement required. Equity includes the underlying shares; Contract price $1000; Strike $125 Note: For written puts under IAS 32R, there are mixed views about the discount rate and the exclusion of shares for EPS. For this example, the rate implicit in puttable stock was used (1.84%) to transfer the equity to a liability. REO Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 26

28 Shares Mandatorily Redeemable for Fixed Amounts Entire amount is liability. Results in same accounting as forward purchase contract and shares. If the timing of redemption is unknown? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 27

29 Shares Mandatorily Redeemable at Fair Value Entire amount is equity regardless of requirement to pay cash. Resolves private company, co-op, and possibly minority interest issues. But how about shares mandatorily redeemable at book value, at multiple of earnings, or at amounts that vary with a subsidiary s share price? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 28

30 Perpetual Preferred Stock Focus of REO is not whether an obligation exists Focus is on expected flows of cash or other economic resources Perpetual preferred stock generally has a fixed payoff, not varying with an ownership interest in common shares So: it would be a liability if ownership relationship means like what the common shareholders have or a proprietor would have. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 29

31 Prepaid Written Put Option Consistent treatment for economically similar transactions such as: Repurchase plus written call option (illustrated) Receivable plus written put option Prepaid forward purchase plus written call option Overcomes inconsistencies found with current GAAP and other approaches Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 30

32 Prepaid Written Put Option Numerical examples of the Reassessed Expected Outcomes (REO) Model - Accounting and EPS effects Prepaid written put option Reassessed Expected Outcomes Equity Interest Current GAAP Share (paid in expense REO REO Basic price Cash Asset Debt capital) (income) Income Shares EPS Income Shares EPS Day One Write option (112.48) Prepay exercise price (781.20) Assess split (431.86) Beginning Balan 100 (668.72) (1,000.00) (1,000.00) Diluted EPS Year 1 Accrue interest (17.47) (17.47) Reassess split (307.34) (0.82) - Ending Balance 150 (668.72) (17.47) (1,017.47) (1,000.00) Year 2 Accrue interest (33.71) (33.71) Reassess split (6.70) (0.85) - Ending Balance 150 (668.72) (51.17) (1,033.71) (1,000.00) Year 3 Accrue interest (35.73) (35.73) Reassess split (16.78) (0.82) - Ending Balance 150 (668.72) (11.44) (86.90) (1,035.73) (1,000.00) Year 4 Accrue interest (38.35) (38.35) Reassess split (45.51) (0.62) - Ending Balance 150 (668.72) (56.95) (125.25) (1,038.35) (1,000.00) Year 5 Accrue interest (42.55) (42.55) Reassess split (106.48) - - Exercise/payoff 1, (1,000.00) - Ending Balance (0.05) (163.43) (167.80) (1,042.55) (1,000.00) Year 6 Invest cash from exerc (1,000.00) 1, Earn interest (50.00) (50.00) (50.00) Reflect new shares - - Ending Balance (668.72) 1, (163.43) (217.80) (1,050.00) (1,050.00) Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 31

33 Prepaid Written Put Option (PWP) Compared to Repurchase + Written Call (R+WC) Fundamental Amount at Components, Pure Unreassessed End of Yr 1 Equity, and Minimum Expected (stock $150) Current GAAP Obligation Outcomes IAS 32R REO PWP R+WC PWP R+WC PWP R+WC PWP R+WC PWP R+WC Cash (668.72) (668.72) (668.72) (668.72) (668.72) (668.72) (668.72) (668.72) (668.72) (668.72) Asset Liability Equity Expense (127.86) 0.00 (17.47) (17.47) (17.47) Earnings EPS No.Shares EPS EPS (diluted) Straight debt rate = 5%; Earnings before interest/gain = $1,000; Notional 8 shares; Physical settlement required; Equity includes the underlying shares to be repurchased; Strike $125 Note: For IAS 32R, there are mixed views about the exclusion of incremental shares for EPS. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 32

34 Variable Share Forward (VSF) + Debt Variable share forward #9 (inexactly) analyzed as a written call for.83 and a purchased put for 1 Payoff Share to Change in Price Counter Price Payoff party 0 (10) (5) Payoff to ^ counterparty Share price > Variable share forward, #9 combined with related note payable Payoff Share to Change in Price Counter Price Payoff party Payoff to ^ counterparty Share price > Remember the flat zone in the middle, and the flatter slope of the right hand portion? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 33

35 Variable Share Forward (VSF) + Debt Payoff to ^ counterparty Journal Entry at Inception: VSF Cash Liability for debt component Liability for middle debt component Equity Component Debt Cash Liability for debt Share price > The liability of $ represents the flat zone (settled with a variable number of shares based on a fixed monetary amt.) Subsequently, the liability is reassessed and adjusted with an offset to equity. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 34

36 Variable Share Forward + Debt (VSF) Compared to Forward Sale + Purchased Call + Written Call + Debt (Combo) Amount at End of Yr 1 (stock $150) Fundamental Components, Pure Equity?, and Unreassessed Current GAAP Minimum Obligation Expected Outcomes IAS 32R REO VSF Combo VSF Combo VSF Combo VSF Combo VSF Combo Cash Liability Equity Expense Earnings EPS No.Shares EPS EPS (diluted) Straight debt rate = 5%; Earnings before interest/gain = $1,000; Notional 8 upside and 10 downside shares; Physical settlement required; Liability includes the related debt; Strike $125 Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 35

37 Convertible Debt That Is Puttable and Callable or Contains Contingent Features Valuation may require a binomial model Puts, calls, and contingent features affect whether the outcome will be equity or liability Statement 133 would not apply to those features unless the feature is unrelated to the equity linkage (for example, a put on equity would not be analyzed under Statement 133, but an embedded gold derivative would be analyzed) EPS reflects the probability of an equity outcome Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 36

38 Summary of Illustrated Advantages

39 REO Illustrated Advantages A single accounting approach applied to all financial instruments Appropriate contingent claims pricing model needs to be generated only once, at inception, for each different instrument, and no issuer has THAT many Unit of accounting is the instrument together with the shares and/or debt that could be issued or removed Consistent accounting and EPS results for instruments or strategies with similar economic effects Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 38

40 Issues, Ramifications, and Challenges Fundamental Differences Conceptual and Practical Questions Revisions to Definitions Linkage Practicability Display Ramifications to Other GAAP

41 Fundamental Differences from GAAP* Options are accounted for consistently, no matter what settlement alternatives are possible Shares mandatorily redeemable at fair value are equity Employee stock option compensation expense is the same, but balance sheet classification differs Equity derivatives are treated differently than under Statement 133 *Note: Some of those differences could be avoided by limiting application of REO to compounds, adding an overriding liquidity test, or exempting stockbased compensation possibilities discussed later in this presentation. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 40

42 Conceptual and Practical Questions Would limiting REO only to equity-linked transactions create another arbitrage opportunity? Can we tolerate asymmetrical accounting by the counterparty? Subsequent conversion/non-conversion/ early extinguishment might not be gradual. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 41

43 Conceptual and Practical Questions Appropriate for net-settled transactions? Example: Cash-settled written call Initial stock price = $ 800 Strike Price = $1,000 Price at Settlement = $1,200 1.Initial Entry 3. Entry At Settlement Asset 349 Equity 1,200 Cash 132 Cash 200 Equity 481 Asset 1, Balance before Settlement 4. Ending Balance Asset 1,000 Equity (240) * Equity 960 * Deficit arises because equity balance before settlement reflects the contractual strike price, but the settlement reflects the current share price. It is the same result we see whenever a company buys in its own shares for more than the issue price. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 42

44 Conceptual and Practical Questions How does the REO approach deal with components that belong in classes of liabilities (or assets) subsequently measured at fair value? Fair value for component. Adjust interest, dividends, initial proceeds? Foreign currency and other embedded derivatives? Apply Statement 133. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 43

45 Conceptual and Practical Questions Resulting interest expense Example: 5 yr. $1,000 convertible debt 1.84% stated yield 5% straight debt rate Scenario: Never goes into the money Current Acctg Straight Debt REO Over the 5 years Aggregate Interest Exp Average Rate 1.84% 5.00% 3.25% Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 44

46 Conceptual Definitions Revisions would be required for: Liability definition in Concepts Statement 6 The focus shifts to lack of ownership relationship. An obligation, even an obligation to pay cash, is a liability only if it does not convey an ownership relationship. Economic compulsion and past practice indicators, which focus on potential for cash settlement, may be moot issues. Asset definition? A right to receive assets includes the issuance or receipt of shares if failing the ownership relationship test Must the entity have the right to control access of the benefit? Discussion of liabilities and equity in Concepts Statement 6. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 45

47 Linkage Would there still be linkage issues? Not as relevant as in current practice or other approaches. However, we would need to consider whether certain debits are contra-liabilities, or credits are contra-assets. Example: the non-equity amount for a written call option issued with or even without straight debt. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 46

48 Linkage and Presentation Example: Written call option issued with 5 yr. $1,000 zero-coupon straight debt, by an issuer that normally borrows at 5% Contra-liability seems appropriate: same accounting as convertible debt But if no related debt (or no debt at all), do we record an asset? Dr (Cr) Cash Liability Contra-Liab. Net Liab. Equity Initial record debt (781.20) Initial allocation call (480.62) Net liab. (431.87) Possible balance sheet presentation: Debt linked to equity instruments $ Less: discount to present value (218.80) portion classified as equity (349.33) Net liability $ Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 47

49 Linkage (cont.) Possible linkage indicators: Issued in connection with? Same counterparty or third party necessary? Interdependency necessary? Existence of collateral or no counterparty credit risk? Other criteria? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 48

50 Practicability Determining the appropriate model to use Is accounting based on contingent claims pricing models too complex for small businesses? Even if the banks that sell them the instruments offer the pricing service? Concerns about effects (some favorable, some not) on companies ratios? Cost-benefit concerns? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 49

51 Display Issues Which instruments should be displayed at gross (liability, asset, or equity) with a contra account? (Examples: convertible debt and puttable common). Will this remove the need for two EPS calculations? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 50

52 Ramifications for Other GAAP Statement 150 and implementation guidance Statement 133 and implementation guidance Statement 128 and Topic D-72 Statement 123R APB Opinion 21 ASR 268 and EITF D-98 Other EITF Issues Current FASB projects IASB guidance Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 51

53 Statement 150 and Implementation Guidance Reaffirms some decisions, changes others Resolves some of the concerns, conceptual and practical, left unresolved by Statement 150 Resolves the issues that prompted partial deferral of effective date Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 52

54 Statement 133 and Implementation Guidance Equity derivatives that convey ownership interests would (and even those that do not, might) no longer be subject to Statement 133. Embedded puts, calls, and contingent features would affect the probability of expected cash flows rather than being subject to Statement 133. Statement 133 precludes hedge accounting if the hedged item is an equity instrument. Would that preclude hedge accounting for effective hedges of the interest rate risk in the debt portions of convertible bond or other bifurcated instrument? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 53

55 Statement 133 and Implementation Guidance How would derivative components be treated in dualindexed instruments, for example, equity instruments with embedded foreign currency derivatives, gold derivatives, or other features based on something other than the issuer s share prices? What about indexation to interest rates or credit risk? Example: forward sale indexed to shares are foreign exchange rate (DIG Issue C8). How would Issue 01-6 be affected, for example, would contingent features based on external factors only affect the expected cash flows? Example: warrant exercisable if the S&P 500 index increases. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 54

56 Statement 123R We could exempt stock-based compensation, but do we need to? Compensation expense, valuation, and timing of recognition for stock options would not change. Recognize increased equity and an asset based on expected outcome? Or net the two in equity in this circumstance? Cash SARs and other net-cash-settled instruments would be equity, and assets, rather than liabilities marked-to-market. Accounting for puttable options and options on mandatorily redeemable shares would depend on the accounting for the underlying options or shares. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 55

57 ASR 268 and Topic D-98 Fundamental change in principles: Classification focused on ownership relationship, not on obligation to redeem Maximum amount of cash to be paid could be shown on balance sheet and then netted Accrual of interest/dividends/gain/loss and resulting EPS differs Focus would be on expected inflow or outflow of economic resources, not on control Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 56

58 Other EITF Issues/SEC Guidance Issues 00-6 and 01-6 the meaning of indexed to The remainder of Issue would be nullified Stock subscriptions receivable Employee Stock Ownership Plan (ESOP) accounting Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 57

59 Current FASB projects Performance reporting Revenue recognition Business combinations and purchase accounting Fair value project APB Opinions 14 and 21 Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 58

60 IASB guidance Further divergence, but would IASB consider converging? Current IAS 32R: Obligations to redeem shares are liabilities regardless of conditionality or ownership relationship. Obligations to issue a variable number of shares issuances are liabilities even if ownership relationship exists Instruments required to be physically settled are presented broad; others are presented net. Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 59

61 Other Possible Ways of Applying REO Application Limited to Compound Instruments Overriding Liquidity Test

62 Application Limited to Compound Instruments REO could be limited to compounds: The definition of compound instrument would be crucial Produces 2 fundamentally different accounting models for economically similar items Implementation issues and opportunities for accounting arbitrage Pressure on linkage Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 61

63 Overriding Liquidity Test REO could be applied with an overriding liquidity test. That is, an instrument is a liability if it requires settlement by transfer of assets even if it conveys an ownership relationship: A less drastic change from existing conceptual framework Open to settlement alternative games puts pressure on determining discretion to settle in shares Opens opportunities for accounting arbitrage and struggles about linkage Private company, co-op, and minority interest issues for shares mandatorily redeemable at fair value (or something near to fair value) would remain open Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 62

64 Timing and Plan to Deliberate REO Deliberations Plan Timing of Documents

65 Deliberations Plan 5/5/04 Informational meeting 5/18/04 Resource group meeting 5/26/04 Decide whether to pursue REO 6/28/04 Linkage and method details 8/4/04 Method details, display, and EPS 9/1/04 Definitions and affects on GAAP 11/19/04 Milestone drafting and review ends 12/15/04 Remaining issues and field visits Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 64

66 Timing of Documents 3/05 Issue Exposure Drafts. 6/05 90-day comment period ends. 3/06 Issue final Statements. Effective in 2007? Financial Instruments: Liabilities and Equity Reassessed Expected Outcomes Model 65

67 Open Discussion

68 Note to Appendixes 1-3 The purpose of the following appendixes is to examine in greater detail the models used under the REO approach to measure the liability and equity components of various financial instruments. They are a look inside the models used to calculate the amounts seen in the presentation, which rely heavily upon the notion of Put-Call Parity and on adaptations of Black-Scholes-Merton formula, for calculating values of components of the various instruments. The appendixes are laid out as follows: Appendix 1: Day One Figures This appendix shows the results of the models for several financial instruments on "Day One" of an assumed five-year maturity. The model for each instrument is based on the same set of inputs that is, the model for Convertible Debt assumes a principal amount of $1,000 and a conversion ratio of 8.00 shares per bond, while the model for a Written Put assumes a strike price of $1,000 per 8.00 shares. That is to illustrate how the different models result in the same accounting results for instruments of different form but identical economics. Appendix 2: Year One Figures This appendix shows the results of the models for the same financial instruments at the end of "Year One" of an assumed five-year maturity. Hence, the model input Maturity in Years is adjusted to reflect that four years remain until maturity. It is also assumed, to illustrate one possible scenario, that the input Stock Price changed over that year from $100 to $150 per share. Appendix 3: Formulas This appendix displays the formulas in each cell, as opposed to the calculated amounts. It may be helpful in developing an understanding of the adaptations of Black-Scholes-Merton used in the models.

69 Appendix 1: Day One Figures Note: This appendix shows the results of the models for several financial instruments on "Day One" of an assumed five-year maturity. Key: Inputs in Blue Component Results in Green Total Values (fair value of entire position) in Red European Zero Coupon Convertible Debt Maturity in Years 5 Convertible Accreted Principal at Maturity $ 1, PV of Convertible Accreted Principal Payment $ Stock Conversion Ratio Stock Price 100 Convertible Parity $ Annual Quarterly Pay Dividend Yield 0 Accreted Conversion Premium 25% Annual Continuous Pay Dividend Yield 0.00% PV of Convertible Parity Discounted to Maturity at Dividend Yield $ PV Factor Discounting to Maturity at Dividend Yield % Convertible Normalized Forward Parity Price $ 1.02 PV of Stock Discounted to Maturity at Dividend Yield $ Logarithm of Convertible Normalized Forward Parity Price Annual Volatility % Convertible Call Done Annual Variance 3.01% Convertible Call Dtwo Total Variance 15.07% Convertible Call None 60.08% Total Volatility 38.81% Convertible Call Ntwo 44.72% Annual Volatility Skew 5.00% Annual Downside Volatility 22.36% Convertible Call One Minus Ntwo 55.28% Annual Downside Variance 5.00% Convertible Accreted Principal Debt Component $ Total Downside Variance 24.99% Total Downside Volatility 49.99% Convertible Parity Delta 60.08% Convertible Stock Component $ Straight Debt Convertible Stock Delta Annual Semiannual Pay Straight Debt Rate 5.00% Zero Coupon Convertible Debt TV $ Annual Continuous Pay Straight Debt Rate 4.94% Annual Continuous Accretion Rate on Zero Coupon Convertible for Zero NTV 1.83% PV Factor Discounting to Maturity at Straight Debt Rate 78.12% Annual Semiannual Accretion Rate on Zero Coupon Convertible Bond for Zero NTV 1.85% PV Multiplier for Annual Semiannual Pay Coupon through Maturity 4.38 Initial Conversion Premium on Zero Coupon Convertible Debt for Zero NTV 14.06% European Cash Coupon Convertible Debt Annual Semiannual Pay Convertible Coupon Rate 2.00% Convertible Annual Semiannual Pay Coupon $ Convertible Coupon Debt Component $ Cash Coupon Convertible Total Debt Component $ Cash Coupon Convertible Debt TV $ 1, Appendix 1 Page 1

70 Appendix 1: Day One Figures (Continued) European Written Put Zero Coupon Straight Debt Plus European Written Call Written Put Strike $ 1, Written Call Strike $ 1, PV of Written Put Strike $ PV of Written Call Strike $ Written Put Number Shares Written Call Number Shares Written Put Parity $ Written Call Parity $ Written Put PV of Parity Discounted to Maturity at Dividend Yield $ Written Call PV of Parity Discounted to Maturity at Dividend Yield $ Written Put Normalized Forward Parity Price $ 1.02 Written Call Normalized Forward Parity Price $ 1.02 Logarithm of Written Put Normalized Forward Parity Price Logarithm of Written Call Normalized Forward Parity Price Written Put Done Written Call Done Written Put Dtwo Written Call Dtwo Written Put None 60.08% Written Call None 60.08% Written Put Ntwo 44.72% Written Call Ntwo 44.72% Written Put One Minus None 39.92% Written Put One Minus Ntwo 55.28% Written Call One Minus Ntwo 55.28% Written Put Debt Component $ Written Call Receivable Component $ (349.33) Written Put Parity Delta % Zero Coupon Debt Principal at Maturity $ 1, Written Put Stock Component $ (319.38) PV of Zero Coupon Debt Principal at Maturity $ Written Put Stock Delta Written Put TV $ Debt Plus Written Call Debt Component $ Stock Plus European Written Put Stock Plus Written Put Parity Delta 60.08% Written Call Parity Delta 60.08% Stock Plus Written Put Stock Component $ Written Call Stock Component $ Stock Plus Written Put Stock Delta Written Call Stock Delta Stock Plus Written Put TV $ Debt Plus Written Call TV $ Prepaid European Written Put European Written Call - By Itself Prepaid Written Put Receivable Component $ (349.33) = Stock Component - Receivable component Prepaid Written Put Stock Component $ (319.38) Written Call TV $ Prepaid Written Put TV $ (668.72) Stock Repurchase Plus European Written Call Stock Plus Prepaid European Written Put Stock Repurchase Plus Written Call Stock component $ (319.38) Stock Plus Prepaid Written Put Stock Component $ Stock Plus Prepaid Written Put TV $ Appendix 1 Page 2

71 Appendix 1: Day One Figures (Continued) European Purchased Put (by itself) European Purchased Call Purchased Put Strike $ 1, Purchased Call Strike $ 1, PV of Purchased Put Strike $ PV of Purchased Call Strike $ Purchased Put Number Shares Purchased Call Number Shares Purchased Put Parity $ Purchased Call Parity $ Purchased Put PV of Parity Discounted to Maturity at Dividend Yield $ Purchased Call PV of Parity Discounted to Maturity at Dividend Yield $ Purchased Put Normalized Forward Parity Price $ 1.02 Purchased Call Normalized Forward Parity Price $ 1.02 Logarithm of Purchased Put Normalized Forward Parity Price Logarithm of Purchased Call Normalized Forward Parity Price Purchased Put Done Purchased Call Done Purchased Put Dtwo Purchased Call Dtwo Purchased Put None 60.08% Purchased Call None 60.08% Purchased Put Ntwo 44.72% Purchased Call Ntwo 44.72% Purchased Put One Minus None 39.92% Purchased Put One Minus Ntwo 55.28% Purchased Put Receivable Component $ (431.86) Purchased Call Debt Component $ Purchased Put Parity Delta 39.92% Purchased Put Stock Component $ Purchased Call Parity Delta % Purchased Put Stock Delta Purchased Call Stock Component $ (480.62) Purchased Put TV $ (112.48) Purchased Call Stock Delta Purchased Call TV $ (131.28) Stock Plus European Purchased Call Stock plus Purchased Call Parity Delta 39.92% Stock Plus Purchased Call Stock Component $ Stock Plus Purchased Call Stock Delta Stock Plus Purchased Call TV $ Appendix 1 Page 3

72 Appendix 1: Day One Figures (Concluded) Variable Share Purchase Contract VSPC Strike $ 1, PV of VSPC Strike $ VSPC Downside Number Shares VSPC Downside Parity $ 1, VSPC PV of Downside Parity Discounted to Maturity at Dividend Yield $ 1, VSPC Normalized Forward Downside Parity Price $ 1.28 Logarithm of VSPC Normalized Forward Downside Parity Price VSPC Downside Done VSPC Downside Dtwo VSPC Downside None 77.15% VSPC Downside Ntwo 59.64% VSPC Downside One Minus None 22.85% VSPC Downside Ntwo Minus One % VSPC Downside Strike Debt Component $ (315.32) VSPC Downside Parity Delta 22.85% VSPC Downside Stock Component $ VSPC Downside Stock Delta VSPC Downside TV Without Contract Payments $ (86.85) VSPC Upside Ntwo Minus Downside Ntwo % VSPC Middle Strike Debt Component $ (116.54) VSPC Middle Number Shares $ VSPC Middle Parity Delta % VSPC Middle Stock Component $ VSPC Middle Stock Delta VSPC Upside Number Shares VSPC Upside Parity $ VSPC PV of Upside Parity Discounted to Maturity at Dividend Yield $ VSPC Normalized Forward Upside Parity Price $ 1.02 Logarithm of VSPC Normalized Forward Upside Parity Price VSPC Upside Done VSPC Upside Dtwo (0.1328) VSPC Upside None 60.08% VSPC Upside Ntwo 44.72% VSPC Upside Minus Ntwo % VSPC Upside Strike Debt Component $ (349.33) VSPC Upside Parity Delta 60.08% VSPC Upside Stock Component $ VSPC Upside Stock Delta VSPC Upside TV Without Contract Payments $ VSPC Total Strike Debt Component $ (781.20) VSPC Middle Stock Debt Component $ VSPC Downside Plus Upside Stock Component $ VSPC Total Stock Delta VSPC Total TV $ Debt Plue Variable Share Purchase Contract Debt Plus Total Strike Debt Component $ - Appendix 1 Page 4