Convertible Bonds Settled for Cash upon Conversion and Balance Sheet Treatment for Certain Sales of Mortgage Servicing Rights
ISSUE NO. 90-19 This EITF issue, Convertible Bonds with Issuer Option to Settle for Cash upon Conversion, discusses how the cash settlement of all or part of the convertible debt's conversion obligation affects the initial balance sheet treatment and subsequent accounting. The facts are these: A company issues convertible debt that may be converted into a fixed number of common shares. (Often, the debt instruments are deeply discounted bonds.) Upon conversion, the issuer either is required or has the option to settle all or part of the obligation in cash. The EITF identified three types of discounted bonds. 1. Instrument A. Upon conversion, the issuer must pay cash to debt holders at the conversion value (the number of shares the holder is entitled to upon conversion x the stock price on the conversion date). 2. Instrument B. Upon conversion, the issuer may choose either cash or stock equivalent to the conversion value as compensation. 3. Instrument C. Upon conversion, the issuer must pay cash for the obligation's accreted value (the debt's carrying amount at conversion) and may satisfy the conversion spread (the excess conversion value over the accreted value) in either cash or stock. Accounting issues. The issues are 1. Whether the issuer allocates any portion of the bond proceeds to equity in order to reflect the conversion feature. 2. How the issuer should account for the excess conversion value over the accreted value. 3. How each instrument should be treated in earnings-per-share computations. (Because this issue affects public companies only, the consensus is not discussed in this column. Refer to the EITF Abstracts for further information.) Consensuses. On issue 1, the EITF concluded bond proceeds should not be allocated between the debt and equity sections of the balance sheet. The EITF adopted the combined approach as discussed in Accounting Principles Board Opinion no. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. Opinion no. 14 says no portion of the proceeds from conventional convertible debt should be allocated to equity due to the inseparability of the debt and the conversion option. It also says other types of convertible debt, not specifically discussed in the opinion, should be accounted for in accordance with their substance. The EITF concluded convertible debt partially or entirely redeemable in cash paralleled conventional convertible debt and should be accorded the same accounting treatment. On issue 2, the EITF concluded instruments A and C should be accounted for similarly to indexed debt obligations, which provide for contingent interest payments in addition to a guaranteed minimum interest payment. The issuer adjusts the debt's carrying amount in each reporting period to reflect the current stock price, but not below the bond's accreted value. These adjustments are included currently in income, not spread over future periods. This decision conforms to conclusions reached in EITF Issue no. 86-28, Accounting Implications of Indexed Debt Instruments, when the contingent interest payment was inseparable from the indexed obligation. Instrument B, however, should be accounted for as convertible debt. If the issuer pays cash upon exercise of the option, the debt should be considered extinguished at that time and the issuer should follow the accounting prescribed by paragraph 20 of APB Opinion no. 26, Early Extinguishment of Debt. That is, the difference of Debt. That is, the difference between the reacquisition price and the net carrying amount of the extinguished debt should be recognized in the income statement as an extraordinary item, if material. ISSUE NO. 90-21 This issue, Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a Subserving Agreement, answers the question of whether the transaction should be accounted for as a sale with a deferred gain or as a financing. …