Convertible Debt and Its Never Ending Financial Statement Destruction

While preparing for the next client argument, I mean discussion, involving the issuance of convertible debt I was reminded of the additional effects certain provisions of EITF 00-19 has on other outstanding financial instruments / derivatives.

As anyone with outstanding convertible debt is aware, the key point to simplifying the accounting for any conversion feature that appears to require derivative accounting is to force the feature into being classified as permanent

While preparing for the next client argument, I mean discussion, involving the issuance of convertible debt I was reminded of the additional effects certain provisions of EITF 00-19 has on other outstanding financial instruments / derivatives.

As anyone with outstanding convertible debt is aware, the key point to simplifying the accounting for any conversion feature that appears to require derivative accounting is to force the feature into being classified as permanent equity.   In general, the best way to classify the resulting derivative as permanent equity is to convince yourself, your auditor, and in most cases the SEC, that your debt qualifies as a “conventional convertible debt” as unclearly defined by paragraph 4 of EITF 00-19 and then by the equally obscure EITF 05-02.

Since most agreements contain provisions for adjustment to the conversion price for various things including additional capital raises or obtaining certain performance milestones, conversion features generally require liability classification.  These are not the standard “anti-dilution” provisions referred to in the standards.  Most conversion price adjustments, regardless of how remote, generally mean the ultimate number of shares required on conversion is indeterminate on the date the debt is issued and likely exceeds the number of shares authorized – requiring liability classification.

Now that you have been politely reminded by your auditor and / or the SEC you may have additional liabilities and on-going income statement effects, the next step, which is often overlooked, is to review all other vested outstanding options and warrants (non-employees only) while the convertible is outstanding.  Since you already determined you don’t have enough authorized shares to settle the convertible debt you also don’t have enough shares to settle all other non-employee vested options and warrants.  As you may have guessed, this requires reclassification of such instruments as liabilities, at their fair value, on the date the convertible debt is issued.  Additionally, these newly found liabilities are revalued on subsequent balance sheet dates with the changes included in your income statement.

The oxymoronic good news:  A significant decrease in your stock price generally results in substantial income statements gains from these derivatives.

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