A 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.

Because the bond agreement required that the bulk of the bond’s value was settled in cash, issuers had to assume — for EPS purposes — that only the much smaller gain, or conversion spread, would be settled in stock (as opposed to the entire instrument). Consequently, companies no longer got to add the instrument’s after-tax interest expense back to the earnings portion of the EPS calculation, but only the shares issuable to satisfy the conversion spread were factored into the EPS denominator. Companies commonly refer to this as applying the treasury stock method to convertible debt. Because the treasury stock method is typically much less dilutive than the if-converted method, this development was viewed favorably by issuers.

To improve upon what issuers considered “a good thing,” investment bankers introduced Instrument X soon after Instrument C made its debut. By 2003, Comerford, then with the SEC, called the debt instrument “the golden goose of convertible bonds” in a speech before the American Institute of Certified Public Accountants.

To be sure, Instrument X solved one of Instrument C’s big problems: to get the EPS benefit, a company had to keep enough cash on hand to pay off the par value of the bonds when investors exercise their conversion option. Unlike with a traditional bond, which allows treasurers to schedule related cash flow until maturity, Instrument C issuers didn’t have control over the bond’s payout schedule, as investor conversion could occur at any time. “That’s a problem for companies that have liquidity issues, even if cash-flow problems don’t emerge until 20 years after the date a 25-year bond is issued,” said Comerford in a recent interview with CFO.com.

As a fix, Instrument X put settlement specifics in the hands of the issuer. Accordingly, when investors exercise their call option, the issuer decides whether to repay the bondholder in cash, stock, or a combination of both. But from an accounting perspective, it seemed that the issuer would no longer qualify for the more favorable treasury stock method, and instead would be forced to use the if-converted method. The resulting assumption would be that some, if not all, of the bond would be settled in shares — the exact result issuers were trying to avoid.

But thanks to a FAS 128 loophole, issuers of Instrument X were allowed to sidestep the conventional accounting treatment. Comerford explains that FAS 128 states that if a company has a past history or stated policy of settling a convertible bond in cash any time it is given a settlement choice, then it can assume cash settlement rather than share settlement for accounting purposes. In his 2003 speech, Comerford addressed SEC concerns about the loophole; mainly that a company’s stated policy or past practice of cash settlement had to be substantive.

For example, a company’s argument would lack substance if management claimed that despite struggling to pay its bills, the company had the ability to settle millions of dollars worth of Instrument X debt in cash, says Comerford. He adds that while there was no specific instance of abuse that prompted the speech, the SEC staff was concerned about the way the accounting guidance “hinged on management’s intention,” and wanted to reiterate to issuers the existing accounting guidance.

At the time, FASB was already discussing closing the Instrument X loophole, but the exposure draft was delayed several times as the standard-setter struggled with international accounting convergence issues, as well as with trying to address EPS guidance holistically, rather than one issue at a time.

With the release of the exposure draft this month, FASB has proposed to close the international accounting gap with respect to EPS guidance. FAS 128 is nearly identical to IAS 33, its international counterpart, in terms of how the metric should be calculated. However, FASB has not set a date for releasing the final draft, says Wyatt, as board members want to review the public comments before they decide how much work is still ahead of them.

Nevertheless, Comerford seems sure about one thing: if the EPS advantage is eliminated, Instrument X will survive only as long as treasurers see an advantage in having settlement flexibility. But he doesn’t expect that benefit to save the bond from extinction.

Furthermore, Willens asserts that investment bankers are probably studying the accounting literature now to dream up new convertible bond products that produce coveted accounting benefits. Perhaps an Instrument Z will be out for the holiday season.