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The verdict is in on "Instrument C" bonds, and all is not rosy.
Robert Willens, CFO.com | US
June 2, 2008
The Financial Accounting Standards Board (FASB) has finalized its "guidance" with respect to accounting for some immensely popular convertible instruments known as "Instrument C." The problem, however, is that the news, as everyone suspected, is decidedly negative.*
Many of the accounting advantages these instruments previously enjoyed will be unceremoniously eliminated and, to make matters worse, the new accounting model with respect to these instruments will be applied "retrospectively" to all periods presented.
The vehicle for this radical alteration is FSP APB 14-1,Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement). The FASB staff position applies to convertible debt instruments (CDIs) that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement. Moreover, convertible preferred shares that are treated as "mandatorily redeemable financial instruments," and are classified as liabilities under FAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, are considered, for purposes of this staff position, CDIs.
Most notably, CDIs within the scope of this staff position are not addressed by paragraph 12 of APB Opinion No. 14 — they will not, therefore, be accounted for as "unitary" debt instruments. Instead, the liability and equity components are accounted for in a manner that will reflect the entity's non-convertible debt borrowing rate when interest cost is measured in subsequent periods. In short, the dreaded remedy of bifurcation has been selected for instrument C. That is, under the new guidance, issuers of instrument C type debt must record the debt and equity components separately.
Allocating Issue Price
The issuer of a CDI covered by this staff position has to first determine the carrying amount of the liability component by measuring the fair value of a similar liability that does not have an "associated equity component." The issuer then has to determine the carrying amount of the equity component by deducting the fair value of the liability component from the initial price of the CDI.
Transaction costs, says the staff position, are allocated to the liability and equity components of the bifurcated CDI in proportion to the allocation of issuance proceeds. Further, these costs should be accounted for as "debt issuance costs" and "equity issuance costs," respectively. The FSP notes that recognizing CDIs as two separate components may result in a basis difference (between the carrying amount of the liability component and the "tax basis" of such liability) that represents a temporary difference within the meaning of FAS No. 109, Accounting for Income Taxes.
So, in most cases, a deferred tax liability will be recorded to reflect the tax effect of this basis difference. In addition, the FSP states that the initial recognition of deferred taxes should be recorded as an adjustment to "additional paid-in capital." In other words, the "debit" is a charge to APIC.
What's more, the CDIs — the accounting for which is governed by the new staff position — will not be eligible for the "fair value option" under FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. Accordingly, these instruments may not, at the issuer's election, be "marked to market" with the resulting change in carrying amount reflected in earnings.
Additional Interest Expense
The effect of bifurcation will be felt by issuers where it matters most — their reported earnings.** Thus, the excess of the principal amount of the liability component over its (truncated) carrying amount is amortized to interest cost using the "interest method." In these cases, both debt discount and debt issuance costs are amortized over the expected life of a similar liability that does not embody an associated equity component. This expected life is not reassessed in subsequent periods unless the terms of the CDI are modified. Moreover, the equity component is not remeasured as long as it continues to meet the conditions for equity classification.
If a CDI is "de-recognized," an issuer allocates the consideration transferred and the transaction costs incurred to, (1) the extinguishment of the liability component; and (2) the re-acquisition of the equity component of the bifurcated CDI. Any difference between the consideration attributed to the liability component and the sum of the carrying amount, and the unamortized debt issuance costs is recognized in the income statement as a gain or loss. Meanwhile, regarding the reacquisition of equity component of the CDI, the issuer is required to recognize the settlement consideration as a reduction of stockholders' equity.
FSP APB 14-1 is effective for financial statements issued in fiscal years beginning after December 15, 2008, as well as for interim periods within those fiscal years. Moreover, the staff position is to be applied retrospectively to all periods presented. This is true even though the CDI being accounted for was issued well before FASB even raised an issue with respect to the accounting for instrument C. The cumulative retrospective effect of the accounting change related to prior periods is recognized as of the beginning of the first period presented. Also, an offsetting adjustment must be recorded to the opening balance of retained earnings for that period.
The FSP, of course, has no effect on the tax treatment of the instruments affected by the new guidance. In fact, for tax purposes, bifurcation of a convertible instrument is explicitly prohibited: The regulations provide that "...the issue price of a debt instrument includes any amount paid for an option to convert the instrument into stock (or another debt instrument) of either the issuer or a related party...or into cash or other property in an amount equal to the approximate value of such stock (or debt instrument)..." See Regulation Section 1.1273-2(j).
A convertible debt instrument which is also a contingent payment debt instrument (CPDI), however, can provide the issuer with "enhanced" interest expense deductions. A CPDI, in turn, is defined as a debt instrument which provides for one or more contingent payments. (See Regulation Section 1.1275-4(a)(1).) For this purpose, a payment is not regarded as a contingent payment merely because of a contingency that, as of the issue date of the instrument, is either "remote or incidental."
Furthermore, a debt instrument does not provide for contingent payments merely because it provides an option to convert the debt instrument into the stock of the issuer, into the stock or debt of a related party, or into cash or other property, in an amount equal to the approximate value of such stock or debt. Nevertheless, it has been ruled (see Revenue Ruling 2002-31, 2002-1 C.B. 1023) that a zero-coupon convertible debt instrument which provides for nominal payments in cases where, during specified periods, the debt trades at or above a certain multiple of its accreted value, does constitute a CPDI.
In those cased, the contingency — the occurrence of which would trigger such payments — was neither a remote nor incidental contingency. In cases where a CPDI is issued for cash or publicly-traded property, it is accounted for under the taxpayer-friendly non-contingent bond method (NCBM). See Regulation Section 1.1275-4(b)(1).
Under this method, the amount of interest expense which is taken into account for each accrual period is determined by first constructing a projected payment schedule for the debt instrument, and then applying rules similar to those for accruing original issue discount on a non-contingent debt instrument. Therefore, the amount of interest that accrues in each period is the product of the comparable yield of the debt instrument (the yield at which the issuer would issue a fixed rate debt instrument with terms and conditions similar to those of the CPDI), and the debt instrument's adjusted issue price as of the beginning of the accrual period.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
*A broad reconsideration of the accounting for all convertible instruments is being undertaken in connection with FASB's liabilities and equity project.
**The FSP does not affect the application of the guidance in FAS No. 128, Earnings per Share, with respect to the calculation of earnings per share. In the case of Instrument C, a "treasury stock" type method is employed, the same method that would be employed if the unitary CDI was, instead, a straight debt instrument which had been issued with warrants.