Capital Markets

Convertibles Rule Weighs Down Earnings

A new study says FASB's rule rewrite is a drag on corporate profits.
Marie LeoneFebruary 5, 2009

The rewrite of an old accounting rule related to convertible bonds has cut earnings-per-share ratios of affected companies by an average 6.5 percent, says new research from RiskMetrics Group.

The revised rule (FSP APB 14-1), which was issued by the Financial Accounting Standards Board staff last May and took effect this quarter, requires issuing companies that have cash-settled convertible bonds to increase their interest expense on the income statement, which ultimately lowers their EPS calculation.

The study examined 133 companies in several industry sectors that were affected by the rule change (see chart.) The companies identified in the study have market capitalizations above $500 million and continue to hold the convertible instruments. They are divided into two groups: those that quantified the accounting rule affect, and those that disclosed that applying the rule would have a negative impact on EPS.

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Of the 65 companies that quantified the change to EPS, Alpharma Inc., which was acquired by King Pharmaceuticals in December 2008, registered the most dramatic change, a 51.4 percent drop in EPS, or $0.15 a share. Other companies, such as wholesale food distributor Nash Finch, real estate investment trust Boston Properties, and European television group CME, all hovered around the study’s average EPS decline of 6 percent.

Some companies, including General Motors, Advanced Micro Devices, Sandisk Corp., and Smithfield Foods, noted a slight drop in the monetary value of their EPS, but said there was no percentage-change impact to report.

Convert chart

The rule targets convertible instruments that give bondholders the option to settle all or part of the bond in cash. According to RiskMetrics, that includes bonds known as Instrument B (that may be settled entirely in cash or stock); Instrument C (that require the principal to be cash settled, while the conversion spread is settled in either cash or shares ), and Instrument X (that may be settled in any combination of cash or shares). The rule also affects convertible preferred shares that are treated as “mandatorily redeemable” and booked as liabilities.

The conversion spread is the profit a bondholder makes if the converted shares are worth more than the cost of the original bond.

Straight convertible debt that must be settled with the corporate issuer’s stock is not affected by the new rule, writes study authors Zhen Deng and Josie Cizek. The rule also does not affect convertible preferred shares classified as equity, convertible debt with embedded options that are recorded as derivatives, and convertible bonds that require cash settlement for fractional shares when converted.

Separating the settlement into cash and shares requires the use of so-called split accounting to record the transaction, says Deng. That is, the issuer must book the debt and equity components of the bond separately. It’s the split that results in a higher interest expense on the income statement that tugs the EPS ratio down. Here’s why.

Deng explains that a convertible bond is attractive to issuers because the interest paid to bondholders is lower than the market rate for most other borrowing. On the other hand, the low-interest bond attracts investors because of the conversion option, which allows the bondholder to turn the debt into equity if market conditions are favorable. For many, convertible bonds were seen as a win-win situation.

But FASB wanted to make sure that companies issuing convertible debt reflected the economic reality of the instrument — that is, the risk associated with the bond — on their financial statements. In the board’s opinion, companies that issued convertible bonds had a tendency to inflate their EPS because the interest expense associated with the potential cash payout was under-reported.

The new rule, however, forces companies to record a higher interest expense — or a higher depreciation expense in the case of debt used for capital improvements — because the debt is calculated as if there were no conversion option, and will be settled in cash. That assumed cash payout includes the additional interest expense.

FASB also is requiring that the rule be applied retrospectively to 2008 financial statements. That means that if issuing companies report a material adjustment to their income statement, they must restate their financial results accordingly, going back two or three years, depending on how many years of comparison reporting they included in their 2008 filings.