COCO bonds: Good finance or puffed-up accounting?

W e recently read about a new financial instrument that has become popular with some shortsighted managers over the last few years. Specifically, we’re talking about “contingent convertible bonds,” known as COCO bonds.

Writing in the Sept. 9, 2003, issue of Business Week, David Henry strongly criticized the generally accepted accounting principles treatment of them, especially the earnings-per-share calculation. Because APB Opinion 14 disallows breaking a convertible into components, managers issue COCOs, but account for them like regular bonds. Henry rightfully reported that the contingent convertibility has led literalist accountants to not acknowledge any dilutive effect in earnings per share from the possibility of conversion.