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.
Impacts to companies:
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: