Peeling away financial reporting issues one layer at a time

FSP APB 14-a: How Long Should it Take to Close a Loophole the Size of Arthur Andersen?

APB 14 was promulgated in 1969 when we were still pretty much in the dark ages with respect to the valuation of derivative financial instruments.  The Opinion addressed two issues, one of them being the accounting for convertible debt. Since the debt features were inseparable from the option to obtain shares (i.e., you gave up the right to the debt payments if you exercised the option to receive shares), separate accounting for the debt and equity features could not simultaneously value both components of this particular hybrid financial instrument. 

Thus, the APB found it in their hearts to allow that convertible debt would be accounted for as if it were straight debt–so long as the debt features were not set at nominal levels.  The rule was chicken salad for companies, for to account separately for the debt and equity components of convertible debt would have meant reporting interest expense at higher rates. 

Apparently, though, the earnings game knows no bounds, as CFOs soon began to tinker with the features of their convertible debt with the objective of circumventing the recognition of potential EPS dilution that could result from additional share issuance.  Eventually, the EITF ‘jumped on their bandwagon in EITF 90-19 by conveniently making a bogus connection between cash-settled and equity-settled convertible debt.  But, as I just explained, the APB’s justification for single instrument accounting was that if you exercise the option, you lose the cash; but, in a cash-settled option you don’t have to give up cash to get the value of the shares. Notwithstanding that annoying detail, the EITF allowed that cash-settled equity conversion options, and variations thereof, could also be accounted for as a single debt instrument, and to sweeten the deal, would also be given more favorable EPS treatment than equity-settled convertible debt.   

"Questions Were Raised" … "Mistakes Were Made"

Now, 17 years later, here is what the FASB has to say about EITF 90-19:

"Because of the proliferation of such instruments in the marketplace over the past several years, questions were raised [how beautiful the passive voice!] as to whether the accounting guidance in Issue 90-19 appropriately reflected the economics of those instruments." (Proposed FSP APB 14-a, para. B2)

Are we to believe that the EITF, FASB and SEC were unaware of these "questions" 17 years ago? The EITF was tasked earlier this year to finally take their chicken salad off the menu, but evidently they couldn’t bring themselves to be the ones to deprive their constituency (basically, the clients of the large audit firms) of something that tasted so good, and could be swallowed practically without chewing.  So, the FASB gave its staff the dirty work, and the result is proposed FSP APB 14-a (in other words, it’s not yet a done deal).   

The Even Bigger Issue that Keeps Me Blogging

Ed Teach of has written a fine article explaining that separate accounting for the debt and equity features will be required, with the result being that reported interest expense will increase and EPS will decrease by adding shares to the denominator of the diluted EPS calculation.  Ed closes the article by quoting a bigwig investment banker lamenting that the new FSP would effectively put an end to cash-settled convertible debt. 

That last part really gets me. A popular tactic of ‘financial management’ owed its existence to a bad accounting rule.  Where have I heard this before? What portion of the productivity of enterprising managers has been wasted in self-interested quests to devise financial arrangements whose sole or main benefit is the exploitation of accounting rules that have been tailor-made for exploitation? 

In too many cases, the FASB and SEC should be held to account for the vast destruction of capital that has occurred by allowing abuses like this one to go on for far too long.  In addition to cash-settled securities, examples that easily come to mind are defined benefit pension plans, executive stock options, so-called ‘special purpose entities,’ ill-conceived mergers and acquisitions, ad nauseum.

Sadly, I don’t anticipate that I will be running out of topics to blog about anytime soon.

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