Under the current accounting framework, any bond issued where the company intends to settle the principal amount in cash and any in-the-money amount in net shares receives the following GAAP EPS accounting:
- Interest Expense: Cash coupon plus non-cash interest amount that, when combined with the cash coupon, equals the hypothetical straight debt rate
- Share Dilution: Treasury stock method for any in-the-money amount
The theoretical non-cash interest makes the GAAP EPS impact of the convertible bond similar to that of straight debt (and potentially worse if the stock price appreciates).
The new FASB standard impacts the EPS calculation for bonds that can be settled partly in cash (including net share settlement and “flexible settlement” bonds). Instead of bifurcating the convertible bond into an OID bond and equity option, the full principal amount of the convertible amount would be booked as debt going forward.
For bonds that can only be net share settled, the changes essentially mean that the theoretical non-cash interest expense is eliminated and the share dilution calculation is unchanged. This would lower the interest expense to be the cash coupon only (instead of the full “straight debt rate”). As a result, net share settled convertible bonds will look much more attractive on a relative GAAP EPS basis.
For bonds that allow the issuer a choice of cash, stock, or a combination of both (“Flexible Settlement”), under the proposed change, full stock settlement is assumed. This settlement assumption is regardless of any stated intention to net share settle. For the EPS calculation, the more dilutive of the cash coupon or full share settlement is used (i.e. “If-Converted method of accounting”). Flexible settlement bonds will now have the same EPS impact as bonds that can only be physically settled.
Impact on New Issuances
Most convertibles issued in the last few years have been structured with flexible settlement. With the new standard, issuers that either value the improved GAAP EPS treatment or are certain that they will always settle the principal amount in cash, should consider structuring their convertible as Net Share Settled only. Alternatively, issuers can still issue a bond with flexible settlement (for the time being), but we recommend including a one time irrevocable option in the indenture to change the settlement method to Net Share.
Impact on Outstanding Convertibles
Issuers with flexible settlement bonds that want to avoid adding all the underlying shares to the diluted share count can likely do this unilaterally:
- Most bonds explicitly permit the issuer to irrevocably eliminate one or more settlement methods. This provision can be used to “convert” a Flexible Settlement convertible bond into a Net Share Settled convertible bond
- In the absence of this provision, most indentures allow issuers to make amendments as long as the changes do not adversely affect the rights of investors. Committing to net share settlement merely relinquishes an issuer’s option, so should be permissible under this provision.
For most issuers, this change will be accretive.
Timing of Adoption
Any company that issues a new convertible going forward, or has an outstanding convertible, will have until the fiscal year beginning after December 15, 2021 to adopt the new accounting standard; however, any issuer will be able to early adopt the standard for any fiscal year beginning after December 15, 2020.
The ASU allows entities to adopt the guidance through one of the two following methods:
- Modified Retrospective Method: Apply the changes from the time of adoption; Recognize the cumulative effect of the change as an adjustment to equity at the date of adoption; No need to restate financial statements or EPS for prior periods.
- Fully Retrospective Method: Apply the changes and disclose the effect on net income, any other affected financial statement line item, and any affected per-share amounts for the current period and any prior periods retrospectively adjusted; Recognize the cumulative effect of the change as an adjustment to equity in the first comparative period presented.
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