No strings attached

FASB not cuckoo for CoCo

Of all the numbers investors are sensitive about, earnings per share (EPS) is at the top of the list. Just ask any company that has missed expectations by a penny or two only to see their stock price plunge as a result. If the punishment at times seems outsized in relation to the crime, it is just further evidence of how much store Wall Street puts in EPS as a barometer of company fortunes.

In light of this, the prospect of the Financial Accounting Standards Board ringing in an obscure accounting change that will have hundreds of companies making unfavorable EPS adjustments, some retrospectively, is unsettling. At the heart of the matter is the proliferation of hybrid debt-equity instruments—specifically, the ability of the Wall Street wizards to structure complex instruments that exploit accounting loopholes far more quickly than the Norwalk bean counters can close them.

Currently it is the convertible debt market that is under the microscope. Because the issue of convertibles may ultimately result in stock issuance, their accounting treatment includes them in the company’s calculation of its diluted share count. But offset against the negative effect of share dilution are savings in interest costs as convertibles carry much lower coupon rates than comparable fixed-rate bonds.

In late 2000, a security called a contingent convertible bond (or CoCo) began appearing. In this variant, the conversion to equity can only take place after a set trigger has been reached. Because the issue of stock is contingent upon an event taking place, the stock issuance associated with the structure is only included in the calculation of the diluted share count once the trigger event has occurred. This means that companies can issue low-coupon convertible debt and so save on interest costs and not have to report the dilution effect in the EPS number until some point in the future (usually when the stock has rallied substantially). The advantage of convertibles is doubled for any company that issues CoCos.

And, not surprisingly, many of them have done so. At last count nearly 300 companies have issued CoCos and almost 40 have more than one issue outstanding. We’re not talking of corporate fringe-dwellers here: the list of names includes many market leaders. For a small number, the contingency events have been triggered and so the accounting treatment is the same as if they had issued straight convertible debt. But for the vast majority, if CoCos had to be accounted for in the manner of regular convertibles, the inclusion of the shares in the dilutive share count would negatively impact EPS, frequently by 5% or more.

That is the accounting treatment that the FASB is now proposing. Despite the many protests that are likely to be launched by the companies that will be affected (and the investment bankers that will also be affected if the market for them dries up), the proposal seems highly likely to be adopted by the end of the year, potentially without grandfathering provisions for existing issues and further, requiring restatement of previous periods.

It could be argued that this is just an accounting change and does not reflect a real change in earnings, but complacency in the face of such revisions would require an indifference to EPS that the market does not seem to possess and investors would do well to be prepared for the impact should the new accounting proposal be adopted.

Louise Purtle is corporate strategist at independent research provider CreditSights.