Lehman sees new accounting rules as deterrent to convertible issuers initially

By Ronda Fears

Nashville, Tenn., Oct. 22 - Proposed accounting changes that would require issuers to bifurcate convertibles into debt and equity components on their balance sheets could be a negative initially, said Venu Krishna, head of convertible research at Lehman Brothers.

The Financial Accounting Standards Board is considering changing the accounting rules for issuers of convertible securities. Under existing rules, convertible bonds are viewed as debt with earnings-per-share impact being captured through the use of the "if-converted" method.

"The current business climate does suggest that there is a fairly high likelihood that issuers of convertibles may be required to treat convertibles differently," Krishna said in a report.

"Convertible investors should be aware of the likely changes in the treatment of convertibles since they have the potential to impact new issuance in a fairly dramatic manner."

This is especially significant, he said, given the significant growth in the convertible new-issue market over the past few years. Also, convertibles have been an important means for corporate America to realign its balance sheets.

Should an accounting change become effective, then the basic requirement to bifurcate a convertible into its debt and equity components may negatively impact new issuance in the short term, he said, though over the longer term this impact may ease should investors focus on cash EPS and cash flow metrics.

"However, there does remain a real risk of EPS sensitive issuers staying away from the convertible market," Krishna said.

Under proposed changes, he said, the initial debt component of the separated convertible that would appear on the balance sheet would be treated as accreting to par over the life of the security.

This means that that the issuer would have to recognize an additional phantom interest expense at the debt component's accreting yield-to-maturity rate on a periodic basis, over and above the actual cash interest expense. As the non-cash phantom interest expense get recognized, net income gets reduced by a similar amount.

"Due to higher interest expense recognition for accounting purposes, the bifurcation requirement may make EPS sensitive issuers reluctant to come to the convertible market," Krishna said.

"A far more ominous impact on issuance is likely to occur should a bifurcation requirement be accompanied by a mark-to-market treatment for the equity component."

Mandatories are likely to be negatively impacted as well, he added, as the FASB reviews its position on variable share forward contracts.

He said the FASB could adopt the changes as early as the second half of 2003 and the new rules could be retroactive.

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