In my last posting I tried to make assets out of liabilities. Now I want to make some profits out of my liabilities. This is a piece of cake under current GAAP but my current favorite again relates to the issue of the convertible debt that seems to be so popular with companies with a bit of a going concern problem.
When you issue the convertible debt with warrants, there are all sorts of nasty minefields that have to be faced to stop the warrants and the embedded derivative or the beneficial conversion feature from becoming a nasty liability all over again rather than being comfortably lost in stockholders equity. EITF 00-19 is the usual problem with all its complex conditions for recognition of those nasty derivatives as equity.
Not a problem. This is about making profits; not recreating liabilities that already exist. All I have to ensure is that I have a seriously declining share price to make the profit. Well actually I make the profit up front and it could come back to bite me later on if I am not ingenious.
What you do off course is split out the warrant and the embedded derivative from the convertible debt at the issue date. That will be done based on the “fair value” using the option pricing model with some huge volatility assessment for good measure. You put those in as separate liabilities because they fail one of the numerous EITF 00-19 tests for classification as equity. Since my share price is declining rapidly, the value of these derivatives drops much faster so the liability starts to disappear. Since the liability is disappearing the gain goes to income as a nice fat illusory profit.
Now of course I do have the problem with the debt. It is a debt that requires interest imputation. However, by pulling out the derivative, the debt is at a really low value so the imputed interest is far less than the derivative gain. It will catch up of course but by then I had better do some fancy debt redemption to get rid of the future interest cost that might hit the income statement in future years.
I liked convertible debt accounting under .APB 14. It was simple. Now it is really silly accounting that creates false illusions.