By Glenn Cheney
Norwalk, Conn. -- The Emerging Issues Task Force of the Financial Accounting Standards Board has issued a proposal that would change the accounting for contingently convertible financial instruments.
These are the bonds affectionately known as "CoCos."
Pending public comment and final decision, the proposal would have companies book the dilutive effects of CoCos as soon as they are issued. Under current common practice, companies book the effects on earnings per share only when a company's stock hits a trigger price that allows the bonds to be converted to common stock.
The proposal may already have affected the prices of shares of companies that have issued a large number of CoCos but not yet reported how their conversion would dilute EPS.
Despite the effect on share prices, Jack T. Ciesielski, owner of R.G. Associates and an EITF member, believes that investors will appreciate the additional information.
"Investors will have more information about the capital structure of a company they are investing in," Ciesielski said. "It's an elimination of a kind of gimmicky approach to presenting information to shareholders. Is it great for shareholders because the share counts go up? Maybe not, but it does let them know what they bought into."
Traditional convertible bonds, of course, are convertible as soon as they are issued. The financial industry generally believes it reasonable to consider convertible bonds close enough to actual shares to be counted as issued common stock. FASB Statement 128, Earnings per Share, requires exactly that.
Contingently convertible bonds, however, cannot be converted until a trigger point, usually the rise of the price of an underlying stock. That trigger price tends to be 110 percent, 120 percent or 130 percent of the price at the date the CoCo is issued. The rule would apply to any other trigger as well.
The trouble is, no one can predict whether that trigger price will ever be reached, let alone when. In fact, regardless of reaching the designated trigger, the instrument may never be converted. Many are not, so corporate issuers are arguing that it would be deceptive to presume that they will be.
Gerard O'Callaghan, a practice fellow at FASB, has seen substantial corporate objection to the proposal, especially among companies that have already issued CoCos. There have been complaints that the change will confuse investors.
"GM's got about $8 billion dollars in CoCos outstanding, so this decision could create quite a negative impact on their earnings per share," O'Callaghan said.
General Motors has sent a comment letter to the EITF, objecting to the proposal on two grounds. One is that, in accordance with Statement 128, the company's financial reports would adequately show the dilutive effects of its CoCos only when conversion is permitted, i.e. when the related stock hits 120 percent of the value at issuance.
"GM believes that there are real economic differences between convertible debt and contingently convertible debt to both the issuer and the investor that would not be recognized by the tentative consensus," the comment letter stated.
The company also protested what it saw as a flaw in FASB's due process and asked that the issue receive at least a FASB staff position or, ideally, a formal board interpretation.
"Our second concern is that, in reaching its tentative consensus on Issue No. 04-8, we believe that the EITF exceeded its authority," the letter said. "GM believes that the tentative consensus is a fundamental change to SFAS No. 128 and the manner in which it has been applied."
CoCos are a relatively new kind of financial instrument.
They first were issued in late 2001 and tend to have maturities of 20 to 30 years, so historical statistics do little to indicate what percent of them might actually be converted to common stock.
Still, the intent of Statement 128 is that EPS reflect the full dilutive effects of not just common stock but all potential common stock. The EITF believes that, despite the unknown destiny of contingently convertible instruments, their hypothetical dilutive effect as common stock should be reported.
O'Callaghan said that representatives from the Securities and Exchange Commission have fully supported the EITF's conclusions. He also sees support from the people who use information from financial reports.
"We've been working with research analysts on Wall Street, and they all support us," O'Callaghan said. "They've all been adjusting companies' EPS for this in the past, even though companies didn't recognize it in their EPS reports."
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