Deutsche: convertible market gets breather on new accounting rules

By Ronda Fears

Nashville, Nov. 7 - The convertibles market has some breathing room regarding proposed accounting changes but there could still be a threat looming, according to Deutsche Bank Securities Inc. analysts.

The Financial Accounting Standards Board is considering changing the accounting rules for issuers of convertible securities, but now it appears that mandatories will be exempt. Under existing rules, convertible bonds are viewed as debt with their earnings-per-share impact captured through the use of the "if-converted" method.

"In the last couple of months, the convertible market in the U.S. has been stalked by the ghost of potential accounting changes. It has been suggested that the lull in issuance in the late summer and early autumn was attributable to concerns about the future treatment of mandatories, in particular, and convertibles more generally," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Thursday. The convertible analysts acknowledged expert assistance in producing the report from Deutsche's strategic equity transactions group and particularly to Craig McCracken and Forrest Gilman.

"Based on the information coming from FASB Board meetings over the summer, these concerns were not exaggerated. Indeed, some auditing houses even published very bearish articles on the possible implications for convertibles," the analysts said.

"However, the pressure on FASB to produce a limited scope statement dealing with the high profile issues and products in the media spotlight has given convertibles some important breathing room."

At its Oct. 30 meeting, FASB tentatively decided to exclude all contracts that require the delivery of shares, including mandatory convertibles, from the scope of Phase I for the first time, in order to get a draft statement agreed upon at the Nov. 13 meeting.

The analysts said it appears that FASB has further limited Phase I to cover just mandatorily redeemable instruments, debt payable in a variable numbers of shares, "dual indexed" derivatives, written puts and forward contracts to repurchase stock.

At this stage, the analysts said, positive points are that mandatories get a stay of execution, so to speak, and there is more time to debate the impact on all convertibles. Also, pressure is removed from the FASB.

More information on "dual indexing" would be helpful, the analysts added, as that could catch mandatories and/or convertibles inadvertently.

In general, the analysts noted that the position of FASB members has not necessarily changed and bifurcation will be problematic for some corporates.

"Bifurcation on its own would be unwelcome for some issuers, especially those not currently applying 'if converted' accounting to their convertibles when computing fully-diluted EPS. But bifurcation alone would probably not have a major impact on the U.S. convertible market," the analysts said.

"The requirement to mark the derivative component to market would be a much more serious issue. This would introduce volatility into the issuer's income statement, and might be a real disincentive for some companies to issue convertible securities."

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