The currently prevalent use of convertible instruments appears to highlight significant inconsistencies in the interpretation and application of the layers of US GAAP that must be navigated when simply trying to obtain the capital necessary to keep the doors open.
Most issuers that I see entering into these types of arrangements somehow find a way to treat embedded conversion features as equity, usually by ignoring the requirements of paragraphs 12-32 of EITF 00-19 and the recently implemented clarification contained in EITF 07-5for SFAS 133 exclusion. These issuers appear to be at least acknowledging the embedded conversion feature by applying the guidance of EITF 98-5 and 00-27 and recognizing a debt discount that approximates the intrinsic value of the conversion feature, thereby increasing the effective interest rates of the debt, sometimes significantly.
The implementation of EITF 07-5 will almost always require derivative treatment under SFAS 133, particularly when the terms of the debt agreement contain holder protection (anti-dilution provisions) for future issuances of debt, equity, or equity linked instrument requiring adjustment to the conversion price.
A few things to remember when analyzing a convertible instrument:
- EITF 98-5 and 00-27 do not apply to instruments considered to be derivatives under SFAS 133 requiring bifurcation from the host contract.
- Instruments accounted for under SFAS 133 require fair market valuation at the issuance date and re-valuation at the appropriate future cut-off dates in contrast to beneficial conversion features that are valued at the intrinsic value onlyon the date of issuance.
- Recognition of liabilities for embedded conversion features on the issuance date can result in significant gains in future periods. Don’t get too excited about this as it is generally meaningless and usually means the issuer’s stock price is declining.
Don’t like any of this? Have a look at SFAS 155…..
It appears the Emerging Issue Task Force (EITF) has provided some seemingly useful guidance as to the determination of the application of SFAS 133. As I see more and more companies issuing various types of hybrid financial instruments in order to fund ongoing capital needs, I also see varying degrees of application of SFAS 133 and its next cousin EITF 00-19.
Sifting through the guidance and corresponding AICPA roadmap to properly account for these transactions seems to be the equivalent of ……… The recent issuance and 2009 implementation of EITF 07-5 Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock seems to alleviate some of the confusion surrounding certain redundant conditions in most financial instrument agreements that we have seen.
For example, several recent issuers entering into convertible debt transactions, with certain similar terms, each have radically different balance sheet presentations. Ignoring the SFAS 155 election (which is another matter of discussion), one issuer determined that SFAS 133 didn’t actual apply to the convertible debt and presented the standard convertible note payable; while another determined that SFAS 133 applied, jumped to EITF 00-19 to determine the classification of the derivative instrument requiring bifurcation, and concluded permanent equity treatment was appropriate; and the third issuer determined SFAS 133 in fact applied, required bifurcation, and treated the derivative instrument as an additional liability requiring periodic revaluation.
While having many recent discussions with CPAs, CFOs, University Professors, and anyone else that might have some insight, including the FASB Staff themselves, we were pointed to the seemingly useful guidance contained in EITF 07-5. In the example above, I see most issuers spending most of the time reaching for non-application of SFAS 133 under the exceptions contained in paragraph 11(a) that states that “contracts issued that are both indexed to an entity’s own stock and classified in stockholders’ equity are not considered derivative instruments”. If the complete blow off of SFAS 133 does not work, as in the case of the second issuer above, permanent equity treatment becomes the next best option under the general guise that the issuer has control over adjustments to conversion prices and amounts or that the likelihood of significant detrimental adjustment in the derivative value is de minimis. This example, in particular, appears to be clarified by EITF 07-5.
For all instruments outstanding in fiscal years beginning after December 15, 2008 it appears the application of EITF 07-5 will correspond with increased application of SFAS 133. The EITF guidance indicates several financial instruments are not actually indexed to a companies and stock and would infer SFAS 133 treatment (liability classification). Paragraph 15 eliminates both common arguments against bifurcation: i) the issuer has the ability to control any conversion adjustment and ii) the probably of making detrimental adjustments is de-minimis. The paragraph further indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument, regardless of the probability or whether or not within the issuers’ control, is not indexed to the issuers own stock.
The inability to conclude that financial instruments are actually not indexed to the issuers own stock, thereby, significantly eliminating the derivative instrument exception paragraphs of SFAS 133 will likely result presentation changes of a large number of small reporting companies and may result in some interesting earnings swings.
Maybe the little used SFAS 155 election for financial instruments warrants further discussion?