Contingent convertibles draw FASB's attention

New York, July 2 - Accounting for contingent convertible bonds has drawn the attention of the Financial Accounting Standards Board - and some in the convertible market believe the structure could be killed off if proposed changes go ahead.

The subject was discussed at FASB's Emerging Issues Task Force on July 1.

Market sources said the task force reached a tentative decision that contingent convertibles should be accounted for on an if-converted basis from their date of issuance - with the rule applied retroactively for currently outstanding securities.

FASB could not be reached for comment late Friday afternoon to confirm the outcome of the meeting.

If the proposal goes through as a new accounting rule, it would be "a big blow" to the convertibles market and many issuers would have to restate earnings, one market source commented.

The contingent conversion structure would cease to be used.

The agenda for the task force meeting noted that issuance of contingent convertibles has grown "significantly" in the past few years, with around $90 billion currently outstanding.

Currently, the stock that would be issued on conversion of a contingent convertible is excluded from the issuer's earnings per share calculations until the contingent conversion trigger is met, unlike the treatment of a regular convertible, which is always included in the EPS.

FASB's current rule for EPS calculation is: "The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied."

FASB also noted that parity provisions and call options that trigger conversion could result in conversion at a much lower price than that in the contingent conversion feature.

The agenda for the task force meeting noted that the board could take the view that the current treatment should continue. Alternatively it could take the view that the contingent trigger must significantly exceed the conversion price on the grounds that all convertibles have a certain amount of contingency given that the stock price must rise in order for investors to want to exercise their conversion option. In a summary of the issue prepared ahead of the meeting, it suggested 10% could be considered a significant margin.

Parity and call options included in a particular convertible structure could also affect the accounting treatment.

In a comment letter to the task force, Morgan Stanley managing director Kevin Woodruff argued that the contingencies can be "quite substantial."

He pointed out that the trend is towards setting the contingent conversion trigger higher. In 2002 there was only one deal with a trigger of 130% or more, in 2003 there were 12 and for 2004 so far there have been 21.

Contingent conversion is often included for reasons other than accounting treatment, he added, listing the more favorable tax treatment of convertible debt, the desire not to dilute the voting power of existing stockholders, and the aim of avoiding depressing the stock price through conversions and subsequent stock sales.

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