Convertible securities

Accounting for financing arrangements that possess characteristics of both debt and equity has evolved into a complex maze that can be difficult to navigate.  As credit markets have tightened, companies are finding themselves seeking prospective investors that prefer to hold financial instruments with elements of both equity upside and creditor protection.  This is often achieved through the issuance of a structured convertible security.

The embedded features and rights within these convertible securities can present difficulties in determining the appropriate classification (i.e., debt or equity), assessing the potential earnings volatility resulting from embedded derivatives that may require separate accounting, understanding the potential impact on earnings per share, and a mix of other accounting and financial reporting complexities.

The accounting and financial reporting complexities may be driven from a combination of embedded rights within “hybrid” securities such as: conversion options, redemption features, mandatory conversion features, increasing rate dividends, call features, price protection features (e.g., down-round provisions), beneficial conversion features, make-whole provisions, and registration rights agreements – amongst others.

Prospective issuers of convertible securities should be cognizant that slight differences in the terms can drastically alter the accounting, which may have a significant impact on financial statements.  Whether it is managing leverage, reducing future interest expense, or seeking financing that may be less dilutive to earnings per share, it is important to be in front of the potential accounting issues when contemplating the issuance of a convertible security.

Staying on top of the accounting nuances involved with issuing convertible securities can help ensure the commercial benefits are aligned with the accounting.

Chad Kokenge, Partner

Impacts to companies:

  • The complexity in accounting for convertible securities can have unexpected financial reporting impacts that need to be fully evaluated; for example, embedded derivatives may need to be bifurcated and reported at fair value with changes in fair value recorded in the income statement each reporting period.
  • Issuers need to weigh the commercial impact of including certain features within convertible securities against the potential accounting and financial reporting results in negotiating the specific terms of the instrument the company will issue in the marketplace.
  • The systems and controls around accounting for and evaluating these instruments may be significantly impacted depending on the accounting for any complex financing structure.

What companies should do:
As the accounting for complex debt/equity financing continues to evolve, it is important to keep ahead of the issues through:

  • Continuous training of personnel to understand the maze of accounting guidance when evaluating convertible securities.
  • Maintaining transparent communication around the key terms being considered and the resulting accounting implications.
  • Establishing procedures to monitor any changes to the guidance in accounting for financial instruments (convertible securities).