Convertible Accounting

Convert Accounting

Beginning on Jan 1, 2009, convertibles with net share settled features were subject to the new bifurcation accounting rule that would more accurately reflect the value of the underlying embedded convert equity option and capture the related dilution.

This change resulted in a larger amount of interest expense recorded on the convert than had been recorded under previous accounting rules. This is due to the interest expense being recorded by the issuer will include a combination of the coupon interest and the accretion of the discount as opposed to just the coupon interest under current rules. Consequently, net income and earnings per share for issuers of these securities will be lower and thus could discourage new issuances.

Barclays published a research note that detailed this accounting rule titled, “Accounting for convertibles – a primer” on October 1, 2009 that does a good job of explaining the concepts. Most of this post is taken from the report.

The accounting treatment depends on the settlement upon conversion. For share settled converts the if-converted method is used and for net share settled converts the new bifurcation method is used.

Share Settled Convert Accounting – If-Converted Method

The accounting for this method of settlement is fairly straight forward. If a convert is fully share settled the convert is recorded on the balanced sheet as 100% debt at issue. There is no accretion through the life of the security. The fully diluted EPS is taken to be the more dilutive of 1) the basic EPS and 2) the EPS wherein the tax adjusted interest expense is added back and the shares underlying the convert are added to the total share count. Typically, the higher the net income relative to interest expense, the more likely the second option will be more dilutive.

Net-Share Settled Bifurcation Convert Accounting

Balance Sheet Impact

The par amount of the convert is broken down into an Original Issue Discount (OID) debt component and an equity (option) component and recorded on the balance sheet at inception. The value of the debt component is calculated first, and the remainder is attributed to Equity (APIC and Deferred Tax Liability if there is no call spread and only APIC if there is a call spread). The OID value of the convert can be calculated by discounting the cash flows of the convert at a comparable straight debt equivalent rate (higher than the coupon on the convert). The OID debt component accretes to par using the expected life of the security (usually the shorter of the first put or maturity). In the case of a plain-vanilla net-share settled convert with no call spread the equity is divided between APIC and a deferred tax liability since the additional OID (non-cash) interest expense is not tax deductible. Where there is a call spread the entire interest expense (cash + OID non-cash) is tax deductible and there will be no deferred tax liability account. An example discussed later will help clarify this concept.

Income Statement Impact

The total interest expense is the sum of the actual cash interest on the convert and the OID non-cash interest expense. The total interest is typically significantly higher than the actual coupon rate of the convertible thus reducing the total income and lowering basic EPS. Tax treatment: for GAAP statements the total interest is assumed to be tax-deductible on the income statement. However for tax-accounting only the cash interest amount is tax deductible in cases where the convert is net-share settled and does not have a related call spread. If there is a call-spread the entire interest amount (cash + OID non-cash) is tax deductible.

Dilution/Share Count

Net share settled convert without a call spread: If the stock price is above the convert strike price the share count is increased by the additional in-the money shares underlying the convert.

Example:
For a $100 million face convert with a strike of $50, 2 million shares underlying the convert. If the stock is at $75 then the in-the money value of the convert = ($75-$50) * 2 million shares = $50 million. And the in-the money shares = $50 million / $75 = 0.67 million shares.

Net share settled convert with a call spread: If the stock price is above the convert strike price the share count is increased by the additional in-the money shares underlying the convert. And if the stock is above the high strike of the call spread the additional shares related to the high strike of the call spread are added to the share count as well. For GAAP accounting the effect of the low strike of the call spread is ignored because it is anti-dilutive. In other words the share count will not be lowered despite the issuer having bought calls at the lower strike.

Example:
Continuing with the previous example, in addition to the 0.67 million shares due to the convert the additional shares attributed to the high strike of the call spread need to be added as well. Let’s assume the high strike on the call spread at issue was set $10 above the convert strike (low strike of the call) at $60. If stock is at $75, the dilution due to the high strike leg of the call will be = (($75-$60)*2 million)/$75 = 0.4 million shares. If the stock were lower than $60 then there would be no additional shares due to the call spread