For the Investor:
By Gary Buesser, FASB Member

Distinguishing Liabilities from Equity (Including Convertible Debt)

Most investors struggle to understand the accounting for convertible debt.  Many have told us they think accounting guidance in this area is overly complex and does not provide useful information.

I’m not surprised. Currently, accounting for convertible debt consists of five different models. Based on my experience as an equity investor, as well as my discussions with investor representatives on FASB advisory groups, I’ve learned that few, if any, investors can name or describe these models. 

Those who are familiar with the models have two primary concerns with them:
  • Three of the models bifurcate the value of a company’s convertible debt into debt and equity components on the balance sheet at origination (see below).  Most investors have told us the separation of convertible debt into debt and equity is not useful because they analyze convertible debt as one instrument. 
  • The separation models recognize an imputed noncash interest expense in addition to the cash coupon interest in the income statement.  This reflects the “market rate of interest” that would have been charged on the debt if no conversion option existed.  Accountants refer to this as the amortization of the debt discount.
Before I joined the FASB, I participated in the Board’s outreach meetings with investors and their advisory group representatives, including the Investor Advisory Committee.  At these meetings, investors told the FASB they are interested in the following information when they analyze a convertible instrument:
  • Potential dilution to equity shareholders if and when the instrument converts to equity
  • Robust disclosure of information about the convertible instruments, including contingent features, and
  • Cash coupon interest expense.
The FASB has responded to that input. We recently issued a proposed Accounting Standards Update (ASU), Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging— Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity.  The project’s objective is to reduce the cost and complexity in financial reporting for convertible instruments and contracts in a company’s own equity while improving the usefulness of the financial information.

The proposed ASU would:
  • Reduce the number of convertible debt models from five to two.  Except for convertible debt with embedded derivatives, most traditional convertible debt will be accounted for as one instrument as shown below.  Convertible preferred stock models would also be simplified.
  • Eliminate noncash imputed interest expense. The interest expense recorded in the income statement would approximate the cash coupon interest expense.
Based on what we’ve heard so far, investors support the FASB’s proposed changes to convertible instruments because they are consistent with how analysts view these instruments.  Investors typically eliminate the noncash imputed interest from their income statement models and most companies “pro-forma” out the imputed interest expense.
Based on what we’ve heard so far, investors support the FASB’s proposed changes to convertible instruments because they are consistent with how analysts view these instruments.

Disclosure requirements for convertible instruments under current GAAP are, in my opinion, robust. They include disclosures of principal amount, coupon rate, maturity or conversion price, number of shares, adjustments to conversion price, and contingencies.

Although accountants generally believe the separation models better reflect the economic costs of convertible instruments, most accounting firm practitioners supported our convertible instruments proposals in their comment letters.

The FASB also proposed to change the method used to calculate diluted shares to account for the potential dilution of convertible instruments.  Today, companies may use either the “if-converted” method or the treasury stock method. This has resulted in different diluted share outcomes, thus reducing comparability across companies.  Our proposal would require companies to calculate diluted shares using the if-converted method for all convertible instruments.

The Board will discuss all input received on the proposal at a public meeting tentatively scheduled for Wednesday, December 11, 2019. I encourage you to follow our progress on the project and continue to provide us with your input.

The views expressed in this column do not necessarily reflect the views of the FASB. Official positions of the FASB are arrived at only after extensive due process and deliberation.