# Convertible accounting: New US GAAP inflates earnings

Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

In our article ‘Zero coupon convertibles do not have a zero cost’ we explore the characteristics and cost of capital of convertible bonds. We explain how a convertible comprises debt and conversion option components and provide an interactive model to demonstrate how the cost of capital for each component, and for the overall convertible bond, can be calculated.

In this article we consider how convertibles and their cost of capital are presented in financial statements, and explain the impact of new US GAAP rules that start to have an effect from Q1 2021. We think that US GAAP fails to reflect the economics of convertible financing. The change also results in further divergence between reporting convertibles under US GAAP and IFRS.

The reporting of hybrid instruments, such as convertibles, is complicated because the accounting for debt liabilities and equity is so different. Whether, and how, a convertible bond is split (bifurcated) between the debt and equity components has a significant impact on reported profit and balance sheet presentation.The cost of debt financing (the difference between the finance raised and the total interest and principal repayments) is reflected as a finance expense which impacts profit and loss. However, there is no finance expense recognised in respect of equity capital. Net income represents the profit that is attributable to all equity investors.

Some information about the cost to common shareholders of non-common stock equity, such as non-controlling interests and equity derivatives, is provided in the form of an earnings attribution and diluted earnings per share. However, we argue that with regard to equity derivatives, this ‘cost’ is incomplete, and the representation of dilution is only partial.1See the section ‘Equity multiples fail to reflect the economic value of equity derivatives’ in our article ‘Enterprise value: Our preference for valuation multiples.

The fact that debt creates an expense, but equity does not, is why the accounting for complex instruments, that have characteristics of both debt and equity, is so controversial and challenging; this includes accounting for convertibles.

## Convertible bond accounting

There are different approaches to accounting for convertible bonds. It all depends on whether or not the bond is split for accounting purposes into its debt and equity components. If the conversion option is bifurcated from the bond component, the effect on financial statements further depends on whether the derivative is classified as a liability or as equity.

The easiest approach to convertible bond accounting is to ignore the conversion option until it is actually exercised. When the bond is issued, the full amount of finance raised is reported as a liability and the interest expense is calculated in the usual way. If the convertible is issued at par, the interest expense will simply equal the coupon payment. The convertible is treated as though it were a straight bond until it is converted. Only at that time is any equity recognised by transferring the liability amount to shareholders’ equity.

The alternative is to bifurcate and separately account for the conversion option from the time the convertible is issued. The bond component is reported at the issue date value of the stand-alone debt cash flows – the debt cash flows are discounted at the estimated debt yield as if it were straight debt. Considering the lower coupon of convertibles this means an amount below par. The accretion of this ‘issue discount’ over the period to the maturity of the bond produces an interest expense that reflects the cost of straight debt for the debt component of the bond. This interest expense is higher than if the conversion option were not bifurcated.

Under a bifurcation approach the remainder of the convertible issue, after accounting for the debt component, is attributed to the conversion option. The separated conversion option could be classified as either a derivative liability or as an equity instrument, depending on the terms of the convertible. For straightforward convertibles the conversion option is equity. Only where there are some types of cash settlement or other complicating features will a liability classification result. We will not go into the nuances of liability versus equity classification here but just focus on the reporting consequences of that classification.

• Conversion option classified as a derivative liability: Normal accounting for a derivative applies, which means measurement at fair value at each reporting date, with the change in fair value reported in profit and loss. Given the resulting earnings volatility, most companies prefer to structure convertibles in a way that avoids the conversion option being classified as a derivative liability.
• Conversion option classified as equity: The issue date value attributed to the conversion option is reported as a component of shareholders’ equity and is not subsequently remeasured. There is no related income or expense reported in profit and loss.

In addition, if the conversion option is classified as equity (whether or not it is bifurcated) the potential dilutive effect of the convertible must be included in the diluted earnings per share calculation.

The best way to show the practical effect of these approaches is through an example. We have based this on the same convertible note issued by Twitter that we used in our article about the cost of capital of convertibles.

In March 2021 Twitter issued $1,438m of zero-coupon convertible notes. The conversion price was set at$130.03, a 67.5% premium above the then stock price of $77.63. If the bond and option components are recognised separately then, based on our assumption that the cost of 5-year straight debt to Twitter is 3.25%2We derive our assumed straight-debt yield from the disclosures made by Twitter concerning the price they paid for the convertible bond hedge we describe below. We assume that the price paid by Twitter for the purchased call ($213m) is the same as the value of the conversion option, which therefore gives a value of the debt component of $1,225m. We then solved for the debt yield inherent in this value of the zero-coupon bond, which comes to 3.25%., we calculate the bond component of this issue is$1,225m and that the conversion option component is therefore $213m. You will find more detail about this calculation and can access our interactive model here. In the following table we show the three alternative methods of accounting described above, applied to this Twitter convertible. For our illustration, we have assumed the bond is issued on the first day of an accounting period. Where the derivative is bifurcated, the interest expense is the debt amount multiplied by the assumed straight-debt yield of 3.25%. This is an accretion of the carrying value and not a cash expense due to the zero coupon. Where the bifurcated derivative is reported as a liability it is measured at fair value in subsequent balance sheets, with changes in value in profit and loss. We have illustrated this by separately showing the impact of a 25% increase or reduction in the stock price during the year following issue. For example, if the stock price rises by 25%, we estimate the value of the conversion option would rise by$70m, with this increase reported as a loss.

#### Alternative approaches to accounting for Twitter’s $1,438m 0% convertible note Not separating the conversion option results in a lower interest expense (zero for Twitter in this case) and hence a more favourable outcome for the income statement. However, it also results in higher debt being reported and hence higher apparent financial leverage. Which approach is used in practice depends on whether the issuing company reports under IFRS or US GAAP. There has always been a difference in the accounting for convertibles, but a recent change to US GAAP that first comes into effect in 2021 has increased the disparity. ## IFRS versus US GAAP Both IFRS and US GAAP require that the embedded derivative is bifurcated and accounted for as a derivative liability when the conversion option does not meet the definition of equity. If the conversion option is classified as equity (which is the case for Twitter and is generally more common in practice), IFRS and US GAAP produce very different results. In IFRS accounting, the convertible is always split into the debt and conversion option components. However, the new US GAAP approach is to ignore the conversion option entirely. Until 20213The new US GAAP requirements for accounting for convertibles must be applied to financial statements for years ending in 2022. Early adoption of the new rules is permitted for 2021 year-ends. Considering the advantage of a lower interest expense we expect most US GAAP reporters to follow Twitter in adopting the new rules early. US GAAP was much more complex, with different approaches being used for different types of convertibles. In fact, there were five different classifications, each with differing requirements, which involved all three of the accounting approaches we describe. One of the main motivations for the recent change was to simplify convertible accounting under US GAAP. In the case of Twitter, all its outstanding convertibles were previously bifurcated and accounted for as we describe above for IFRS. Going forward, these convertibles, along with the new issue in March 2021, will be accounted for without bifurcation under the new rules. We disagree with the change. As we explained in our previous article, convertibles are hybrid instruments with a cost of capital that is a combination of a cost of debt for the debt component and a cost higher than the cost of equity for the conversion option. Reporting the convertible coupon as the only expense does not faithfully represent the economics of convertible financing. In our view, the change to US GAAP is regrettable and not in the interests of investors. You will see the effects of the new US GAAP rules for the first time in Q1 2021 financial statements. Convertibles, like those issued by Twitter, that were previously reported as part debt and part equity due to the bifurcation of the conversion option under prior US accounting, will now be reported as a single debt liability. This will result in a lower interest expense, higher earnings and higher basic EPS. ### Impact of the change on Twitter Q1 2021 financial statements The new US GAAP rules apply not only to the convertible issued in Q1 2021 but, in addition, to other outstanding convertibles issued by Twitter in prior periods. The change has been applied retrospectively,4We note that Twitter has used the so-called ‘modified retrospective’ method for transition to the new approach, as permitted by US GAAP. This means that from now on the new accounting is applied to all convertibles, including those issued in the past. However, the reported results for prior periods are not restated. Not only do we not like the new accounting we also do not like this transition approach because it leads to a lack of comparability of reported results pre and post the change in US GAAP. We see no reason why prior periods could not have been required to be restated using the ‘fully retrospective’ transition method. which means that past convertible issues will be adjusted. The impact of restating these onto the new basis can be seen below, together with the recognition of the March 2021 issue (the ‘2026 Notes’). #### Twitter: Change to convertible note balance sheet presentation Notice that on March 31, 2021 there is no longer any equity component and that the unamortised discount related to the original recognition of this equity component has also gone (all that is left is the unamortised issue costs). For example, in the case of the 2025 notes the conversion option was originally recognised equal to$121m, which would have created an equivalent discount for the bond component. The amortisation of this discount since the date of issue results in the lower amount of $114m that affects the net carrying amount. All of this is eliminated when reporting in Q1 2021, with the carrying amount of the debt ($1421m) and equity (zero) components being calculated as though the new accounting had always been applied.

The overall result (described by Twitter in the disclosure below) is an increase in convertible debt liabilities of $290m, a reduction in equity due to not recognising the conversion option of$568m (which is net of a deferred tax effect) and an increase in reserves of $345m, due the lower cumulative interest expense of past periods. It is not possible to precisely determine the profit and loss impact of the change to convertible accounting in Q1 2021 because there is no disclosure of what the profit would have been without the change. However, we can get a pretty good idea. The Q4 2020 convertible discount amortisation, which no longer applies in 2021, is$27m. In addition, Twitter provided a useful disclosure in its 2020 annual report in which it explains the accounting change. This states that the “new guidance is anticipated to reduce interest expense by approximately $100.0million”. The annual impact is certainly material to your analysis, considering that Twitter reported an adjusted (non-GAAP) pre-tax profit of$558m5The non-GAAP result is after adding back both the stock-based compensation expense and the convertible bond interest accretion that was recognised in prior periods before the recent change. We do not agree with either adjustment for the purpose of assessing performance. Without these adjustments the Twitter pre-tax profit is negative. in 2020 and on a GAAP basis a pre-tax loss.

#### Twitter: Anticipated impact of change to US GAAP on convertibles

The change in US GAAP certainly provides a material boost to reported earnings of Twitter and probably many other US GAAP reporters. In our view, the new approach understates the interest expense and does not provide investors with a reliable measure of earnings. The problem for investors is made worse where companies apply so-called convertible bond hedges.

## Accounting for convertible bond hedges

In our article about the economics of convertible bonds we explain how hedging derivatives are used to change the characteristics of convertible financing. A common approach, also used by Twitter, is to purchase a call option to offset the conversion option embedded in the convertible and to issue a warrant with a higher exercise price. The net effect is to make the convertible more bond-like by increasing the effective conversion price, thereby reducing the potential dilutive effect of the convertible.

Twitter paid a net $52m for their ‘hedge’ which comprised a purchased call with an exercise price equal to the conversion price of the convertible of$130, for which they paid $213m, offset by receiving$161m by issuing a warrant with the higher exercise price of \$163. The hedge does not change the debt component of the convertible because the coupon and maturity payment (assuming no conversion) remain the same. It does increase the effective exercise price, and reduce the value, of the equity component of the combined instrument.

The accounting for the derivative overlay is the same under both IFRS and US GAAP – as long as the derivatives qualify as equity (which they do for Twitter), their issue proceeds or cost would increase or reduce shareholders’ equity.

Under IFRS this works out fine because the conversion option is already reported in equity and therefore adding the derivative structure results in merely a change in the equity component of the convertible, which correctly reflects the economics. However, there is a problem under US GAAP.

For US GAAP reporters the conversion option is not separated and, as a result, is not reported in equity. This creates an inconsistency with the offsetting derivatives. In effect, charging the cost of the hedge to equity is the equivalent of charging interest payments directly to equity.

This is made obvious by considering an extreme case of an issuer simply offsetting the conversion option with a purchased call but with no issued warrant. This structure results in a synthetic zero-coupon bond (assuming, like Twitter, the convertible has a zero coupon) with a net zero equity component. Under IFRS, the accounting would match the economics, with the issue discount correctly accreted and reported as interest expense. However, under US GAAP the effective interest cost (equal to the purchase price of the hedge) is charged directly to equity with no interest reported (on what is economically straight debt) in profit and loss.

We wonder whether the sudden popularity of convertible bond issues in the United States, particularly when coupled with convertible hedges, has more to do with this advantageous accounting presentation than it does with any economic rationale.

## Diluted EPS

Under both IFRS and US GAAP the dilution effect of convertibles is calculated using the ‘if-converted’ method. This means adjusting earnings by adding back the convertible interest expense (if any) and increasing the share count by the number of additional shares that would be issued if the bonds were fully converted. This results in the same diluted EPS under IFRS and US GAAP, even though earnings before dilution differ.

Until the recent change in US GAAP the treasury stock method was also used. This resulted in no dilution as long as the conversion option was ‘out of the money’. The switch to the if-converted method will result in greater dilution for many companies and will achieve welcome alignment with IFRS. Nevertheless, in our view, both US GAAP and IFRS accounting for the dilutive effect of convertibles is deficient.

The problem with the if-converted method is that it ignores that whole point of convertibles – namely investors have an option to convert. The diluted EPS reflects the assumption that shares have already been issued at the conversion price, which, considering this is usually significantly above the stock price at the time the convertible is issued, inevitably presents a favourable picture. In our view, dilution calculations should take into account the fair value of options and not intrinsic value (which is the case for the treasury-stock method) or ignore the option altogether in the case of convertibles.

## Another reason why you should use enterprise value

When making global comparisons, having different outcomes for convertible accounting under IFRS and US GAAP may be a significant problem. Unfortunately, making adjustments to achieve comparability is difficult and requires a lot of effort.

However, there is an easier solution. The best way to include convertibles in your analysis is by focusing on their fair value as part of a market enterprise value calculation or in the enterprise to equity bridge. This avoids all of the accounting problems we describe above, including the comparability issues. We have previously emphasised how we think an enterprise value approach to analysis is superior and this is another example of why this is so.6 On this basis, the questions of whether or not to bifurcate, and how to measure interest expense and dilution, are irrelevant.

Nevertheless, we recognise that, in practice, earnings, EPS and related analytical metrics (such as return on equity and price earnings ratios) are important. This is why we think it is vital that accounting standard setters get convertible bond accounting right.

We hope that the IASB does not follow the FASB in their ‘simplification’ of convertible accounting and that both FASB and IASB will review diluted EPS to make it better reflect the true economic cost of equity options.

## Insights for investors

• If a conversion option is classified as a liability it is bifurcated and reported at fair value through profit and loss under both IFRS and US GAAP. Most companies seek to avoid this because of the resulting earnings volatility.
• Under IFRS, conversion options classified as equity are reported in shareholders’ equity. This results in the bond component being reported at a discount to the issue price with a consequent interest accretion expense.
• Under new US GAAP rules, a conversion option classified as equity is ignored. This results in a lower interest expense compared with IFRS. We do not believe this produces a faithful representation of the finance cost.
• Both IFRS and US GAAP use the ‘if-converted ‘method to report the EPS dilution effects of convertibles. We think this understates the economic effect of the conversion option.
• Convertible bond hedges exacerbate the distortion that results from US GAAP.  The potential for ‘accounting arbitrage’ may partly explain the recent surge in the popularity of this form of financing by US companies.
• The challenges of convertible bond accounting is another reason why it is better to focus on enterprise value and related metrics. What matters is the fair value of this claim on enterprise flows and whether the related cost of capital represents efficient financing.

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