FASB decides to alter accounting treatment of convertibles with cash settlement

By Rebecca Melvin

New York, March 26 - Convertibles that provide for cash settlement of principal amount upon conversion - which is most of them nowadays - will be subject to a new accounting standard taking effect Jan. 1, 2009, according to a decision of the Financial Accounting Standards Board directors on Wednesday.

The final rule will go forward largely unchanged from last summer's proposed one, except for the date effective and some explicit disclosure requirements that are in addition to those required under applicable U.S. GAAP.

The change will be retroactive to 2007, meaning that 2009 10-K filings will need to show adjustments for years 2008 and 2007 as well.

Under the new rule, the liability and equity components of convertible debt that may be settled in cash upon conversion have to be accounted for separately in a manner that reflects the issuer's nonconvertible debt borrowing rate.

The liability portion will be treated as straight debt, so issuing a convertible of this variety will offer no advantage over a straight debt instrument on that side of the balance sheet. But its equity component treatment will not change, and the advantage there remains in place: less dilutive earnings-per-share treatment.

That means issuers will have to report significantly higher interest, which will reduce net income, according to FASB practice fellow Brian Stevens.

This will make the instruments less attractive relative to other debt, as issuing entities now have to allocate the paper between both liability and equity, resulting in a higher interest on the liability component.

The new rule, FSP APB Opinion No. 14-1, deals with convertibles that may be settled in cash upon conversion and partial cash settlement. It doesn't contain any discussion of debt instruments with embedded conversion options that are indexed to the issuer's own stock but allow the issuer to settle its obligation to the holder in cash upon conversion.

The preponderance of convertibles issued since 2003 have cash conversion or partial cash settlement. These instruments differ from traditional convertibles typical prior to 2003, which had a binary outcome: either the instrument was in the money and would be converted to stock, or they weren't in the money, and the debt was repaid.

The FASB changes come following questions that were raised as to whether existing accounting guidance appropriately reflected the economics of the newer instruments.

Merrill expects few redemptions

Merrill Lynch said in a report Wednesday that the overall methodology of this new rule will "misrepresent the amount of debt on the balance sheet and distort most leverage and liquidity ratios."

"As of today, about 65% of convertibles by market value in our master index (All US Convertibles Index) have either net share conversion settlement (48.3%) or cash/stock/combo conversion settlement (16.4%)," the Merrill report said.

"Although we perceive this accounting change as a big negative for the convertible market, both issuers and investors have had some time to absorb and digest it.

"The primary market strength that followed the original FSP wording showed that the convertible market will always be attractive for many issuers, especially in times of high volatility and wide spreads.

"Moreover, the full retrospective restatement requirement, while very draconian for the current convertible issuers, will likely keep accounting-induced redemptions out of the market very limited," the Merrill report said.

The new FASB accounting standard will be available to the public in its final form by early May.

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