A Splitting Headache?

A new FASB proposal would apply split accounting to cash-settled convertible securities, and could dramatically curtail their use.
Edward TeachSeptember 14, 2007

A new proposal by the Financial Accounting Standards Board could permanently dampen the current enthusiasm for so-called cash-settled convertible debt. Such securities have accounted for the lion’s share of convertibles issued on Wall Street for the past two years or so — billions and billions of dollars’ worth.

Unlike straight convertibles, cash-settled convertibles can be settled all or partially in cash. In the latter case, the issuer settles the accreted value (generally the principal amount at par) for cash and issues shares for any conversion value in excess of the accreted value (the conversion spread).

Cash-settled convertibles are treated wholly as debt for accounting purposes, and that’s why they’re so popular. The issuer’s reported interest expense need reflect only the stated value of the security — which, thanks to the conversion option, is usually well below the yield a straight debt instrument would have to offer.

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FASB’s new proposal, Staff Position No. APB 14-a, requires that cash-settled convertibles be treated as having both a debt component and an equity component. Applying such “split accounting” would cause an issuer’s interest expense to rise, and may trigger temporary tax differences under SFAS No. 109. Moreover, the new rule must be applied retroactively as well as prospectively; the accounting for existing convertibles must be adjusted whenever previous accounting periods are presented.

Under APB 14-a, an issuer must assign a fair value to the debt component of the convertible, either by comparing the fair value of a similar security (sans the conversion feature) or by using an expected present-value technique. That value is recorded as debt, and subtracting it from the initial proceeds from the security gives the value of the equity component.

The value of the equity component represents the debt discount of the convertible, which will have to be amortized to interest expense over the expected life of the security. “Issuers are going to report substantially more interest expense,” says Robert Willens, managing director and tax and accounting analyst at Lehman Bros. in New York. That, in turn, could have a significant impact on reported net income and earnings per share.

FASB has set October 15 as the deadline for comments on APB 14-a, Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement). But Willens thinks the new rule is all but a done deal, pointing out that it has been in the works for months and FASB has had plenty of time to consider the issue. The rule would apply to financial reports for fiscal years beginning after December 15, 2007, including interim reports.

What will be the fallout from the new rule? “I don’t think cash-settled convertibles will be issued anymore,” predicts Willens. The rules “rob the securities of just about all their attractiveness. I’m hearing these things will become extinct.”