I have noticed a few companies using some ingenious accounting to create assets by issuing liabilities. One would have thought that debit cash credit liabilities would be a fairly simple transaction when you issue debt.\u00a0 Not so when that debt is convertible debt issued with a warrant.<\/p>\n
The way the scheme runs is a follows. The text books and the ancient APB 14 tell us that when you issue debt with detachable warrants you have to separate the warrants out from the debt and take the value assigned to the warrants to paid in capital.<\/p>\n
So I start off with my $10 million of debt and the first thing that I do is a valuation of the warrants. Now if I really work on the valuation of my warrants by using a really high assumed volatility for my shares I can come up with a valuation for my warrants which is greater than the value of the debt. Because I am using the Black Scholes valuation model I can come up with a \u201chighly objective\u201d valuation of these warrants. I therefore ascribe this \u201chighly objective\u201d valuation of my warrants and then assign additional proceeds to the debt as required by APB 14. Let me assume that my warrants are valued at $10.5 million.<\/p>\n
So I do the following:<\/p>\n
Debit cash \u2013 $10 million
\nAPIC stock warrants \u2013 $10.5 million
\nUnamortized convertible debt \u2013 $0.5 million<\/p>\n
So far I have created a mere asset of $0.5 million but there is more to come. I may have an embedded derivative for the conversion feature. Alternatively, if I don\u2019t have an embedded derivative, I probably have a beneficial conversion feature that requires separate recognition. Later discussions will deal with ways to play around with these problems but just for the heck of it let us assume they exist. Based on the above situation I have a beneficial conversion feature of $10.5 million. The debt is on my balance sheet as an asset of $0.5 million but I am going to redeem it at $10 million. So now let us extract the beneficial conversion feature from the debt and account for it separately.<\/p>\n
Debit Unamortized convertible debt \u2013 10.5 million
\nAPIC conversion feature \u2013 10.5 million<\/p>\n
So now my $10million debt is on the balance sheet as an $11 million asset.<\/p>\n
Of course I can do better than that. When I issue this debt I always pay the folk that arrange for the issue of debt in stock warrants. I can\u2019t obviously afford to pay them in cash since I am a struggling company having to get financing however I can. The stock warrants of course that I give to my promoters are debt tissue costs. The equally antique APB 21. So any cost that I incur from issuing this debt now goes as a deferred charge asset as follows assuming that we give our promoters a reasonable 10% commission for their efforts.<\/p>\n
Debit Unamortized convertible debt \u2013 1 million
\nAPIC promoter warrants \u2013 1 million<\/p>\n
Now I have managed to create a $12 million asset out of my$11 million dollar debt liability issue. Does this seem right? I seem to be astray by a mere $23 million.<\/p>\n
If this doesn\u2019t seem right, it is because you have to think about the prepaid interest. You have given \u201cvaluable\u201d bits of paper to your investors in the form of the warrants and so you have an apparent interest rate of probably about 100% a year that you have prepaid.\u00a0 So it has to be an asset. Surely??<\/p>\n
Does this asset creation actually work? Yes, but you have to be very, very careful about running into potential minefields like EITF 00-19, FAS 133, EITF 05-02 etc etc. More on those at another time. Hey help us to generate fake profits while creating liabilities. It all seems a bit back to front.<\/p>\n","protected":false},"excerpt":{"rendered":"
I have noticed a few companies using some ingenious accounting to create assets by issuing liabilities.<\/p>\n","protected":false},"author":7,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[3],"tags":[12,22,23,4,5,6,9,24,25,26],"class_list":["post-16","post","type-post","status-publish","format-standard","hentry","category-accounting","tag-accounting","tag-apb-14","tag-assets","tag-conversion","tag-convertible-debt","tag-derivatives","tag-liabilities","tag-objective-valuation","tag-stock-warrants","tag-valuation-model"],"_links":{"self":[{"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/posts\/16","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/users\/7"}],"replies":[{"embeddable":true,"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/comments?post=16"}],"version-history":[{"count":0,"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/posts\/16\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/media?parent=16"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/categories?post=16"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.excelsisaccounting.com\/blog\/index.php\/wp-json\/wp\/v2\/tags?post=16"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}