VideoA highly structured convertible bond, considered by many to be a corporate treasurer's dream, is about to fade from memory if accounting rulemakers and regulators get their way.
The Financial Accounting Standards Board is circulating a draft proposal to revise FAS 128, the rule related to how companies account for earnings-per-share calculations. The upshot of the proposal is that it shuts down the favorable accounting treatment for a net-share-settlement bond known as "Instrument X."
In short, Instrument X bonds allow issuing companies to choose whether they want to settle the bonds in cash or shares. In doing so, issuers can also avoid diluting EPS to the same extent as with traditional convertible bonds, and at the same time decrease interest expense on their income statement. However, the FASB exposure draft, which is out for public comment until December 5, would eliminate the EPS advantage.
Without the EPS advantage, it is likely that corporate issuers will abandon Instrument X. The FASB proposal "will put a damper on Instrument X bonds, or eliminate them all together," opines Robert Willens, a tax and accounting expert who runs an eponymous consultancy.
Others agree. According to Robert Comerford, a partner with Deloitte & Touche and former professional accounting fellow in the Securities and Exchange Commission's Office of the Chief Accountant, corporate treasurers that consider issuing the bond solely for the EPS benefit will no longer be keen on the idea. "My guess is that the audience of people issuing Instrument X bonds will shrink if the FASB proposal is approved in its current form," he says.
The proposal was drafted to head off abusive practices related to Instrument X, says FASB project manager Sheri Wyatt. Specifically, the rule rewrite does not allow companies to rely on past history or company policy when making accounting assumptions about settling convertible bonds using cash, rather than shares, she explains.
By forcing companies to account for convertible bonds as if they were converted into shares, FASB would wipe out the primary accounting benefit of the bond; namely, the ability for companies to avoid EPS dilution. But coming up with accounting guidance to address potential abuse has never been easy, as FASB has wrestled with related issues for the past 20 years.
Instrument X was created in the early 2000s by investment bankers who spotted an opportunity to exploit bright-line accounting rules. By marrying several complex accounting concepts, they produced a capital-raising tool with "a trifecta" of advantages, posits Comerford, who dubbed the bond Instrument X in a 2003 speech he gave while with the SEC. Issuers get "all three things that would be important to a company: lower interest expense, flexibility with regards to bond settlement, and preferential earnings-per-share treatment."
In general, investors and analysts regard diluted EPS as a critical performance metric because it provides a worst-case-scenario look at earnings. Into the ratio is factored all the common shares that a company has the potential of issuing, including convertible debt and stock options that may be converted in the future. A diluted EPS calculation divides the company's earnings by the sum of the "all-in" common shares outstanding. In contrast, basic EPS, which is a more favorable metric from a company's point of view, takes into account only common shares outstanding, ignoring the dilution risk posed by convertibles.
The accounting for convertible bonds is complicated, but it provides insight into how accounting loopholes emerge. First consider a plain convertible bond that is settled, or repaid, using only the issuer's stock. In practice, that means investors exchange the bond for a set number of company shares, and a profit is made if the converted shares are worth more than the cost of the original bond. That profit is referred to as the conversion spread.
Traditionally, issuers have liked convertible bonds because the interest rate paid to investors is set lower than on a conventional bond, so the company records a lower interest expense on its income statement. Despite the lower coupon rate, the bond still attracts investors because the interest is supplemented by the embedded call option on the issuer's stock (the conversion option), which gives investors the opportunity to benefit from a rise in the company's stock price.
The downside for issuers, however, is that convertible bonds dilute a company's EPS. Under FAS 128, companies are required to apply the "if-converted" method of computing diluted EPS, whereby an issuer assumes that the bond will be repaid using company stock. The shares are then added to the common shares outstanding tally, and earnings are divided by the total to produce the diluted EPS.
The dilutive effect, however, is partially offset because under FAS 128, companies can add their after-tax interest expense back to earnings. The company assumes — for accounting purposes — that the bonds will be converted into stock, so it does not have to pay out the after-tax bond interest amount that accrued for the period.
C-ing Is Believing
In the 1980s, investment bankers developed a net-share-settlement convertible bond that could be settled in cash and shares. Several accounting-rule adjustments followed, and by 1990, a FASB task force issued definitive guidance for the bond that it dubbed "Instrument C." That new guidance, contained in EITF 90-19, also gave rise to beneficial EPS treatment, in that companies were required to settle the par value of the bond in cash, and the conversion spread in shares.
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