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…..