Accounting for a Sweet Co-Co

Prof. Robert Bloomfield of Cornell University posted an interesting accounting question on the FASRI (FASB Research Initiative) blog. I'm taking the liberty of repeating it here in its entirety:

A policy proposal floating around these days is to require banks to issue contingent convertible debt:

My [Mankiw's] favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

A lawyer asks how these might be structured.  This accountant asks:  how would you account for them?  Note that unlike many contingent convertible securities, the event on which conversion is contingent is a regulatory action.

I am attracted to the accounting question because I think the policy proposal itself is a brilliant idea; and because it dovetails nicely with my last post on the FASB/IASB deliberations on liabilities/equity classification. For the sake of the points I would like to make, I'm going to make three questions out of Rob's single question:

1. How would the contingent convertible debt (known in the trade as a Co-Co) be accounted for under current GAAP?
2. Would the answer change if current FASB proposals became final rules?
3. How should the Co-Co be accounted for?

Current GAAP

I could not find specific GAAP for a Co-Co, but I can't be sure that none exists -- in part because the FASB's Accounting Standards Codification is so darn hard to read! There are many redeeming qualities of the Codification; however, it seems to sacrifice readability for systematic presentation. I used to think that some of the pre-codification Original Pronouncements read like gibberish; but now, alas, I pine for them.

So, here goes nothing.  I surmise that GAAP does not make a distinction between regulatory events and other events triggering conversion.  Thus, it would require that this particular Co-Co be accounted for as straight debt until conversion actually occurred. That accounting actually seems reasonable until we have a bank whose financial condition may actually be getting to the point where the regulator would flip the switch to convert the debt to equity. For simplicity, let's assume the debt was issued at par. Upon conversion that entire amount would have to be transferred to shareholders equity (probably through net income) in one fell swoop as of the date of conversion.

A big one-time credit to equity smacks of a rule devoid of any intent to provide timely information to investors. The economic value of the debt would have been declining as conversion inexorably approached, and current GAAP wouldn't have cared less. So, in the period that the regulator flips the debt over to equity, the huge cumulative catch-up adjustment to the debt could swamp the operating losses of the current period, which surely must be occurring. If the debt had been marked to market whie the bank was heading toward its nadir, the trends in the earnings available to the pre-conversion equity holders would have been reflected in a more timely and relevant fashion.

Future GAAP

Of the accounting that would occur if certain current FASB projects came to fruition as planned, I am more certain.  Starting with the fair value project, the debt would be fair valued each period. That's a good thing, but the Co-Co also exposes yet one more (see my previous post) hole in the rules-based liability/equity project.

Let's take a bank that has the following components to its capital structure: (1) the Co-Co, (2) call options on its common shares (which may only be settled by issuing common shares), and (3) common shares. According to the FASB's current position, the options will be classified as equity; but the Co-Co, which also contains a conversion option) will be classified as debt unless converted. Although the Co-Co would be fair valued each period, such treatment will be inconsistent with the treatment of the call option, the opening value of which will sit in the equity section of the balance sheet like cream cheese on a bagel forevermore. The economic events that could cause a change in both the fair value of the Co-Co and the option would be ignored as to their impact on the option, but the impact on the Co-Co would be recognized.

The accounting treatment for the option and the Co-Co would differ for no good reason.  Both would affect the economic position of the current shareholders, but only the effect caused by the change in the value of the Co-Co would be recognized.  This is just one of many reasons why the FASB should revert to its recently abandoned principled stance: it should classify all financial instruments as either assets or liabilities, except for common stock.

Accounting Onion GAAP

Rob Bloomfield correctly observes that lawyers would have to be consulted to precisely specify the Co-Co that Mankiw and others have envisaged. When considering current or future GAAP, I risked putting the cart before the horse by not anticipating key terms of the arrangement. That's because one of the huge problems with rules-based accounting (especially for financial instruments) is that the standards promulgators must ever be on the ready to publish new rules as those pesky financial engineers devise clever ways to circumvent the fences that have already be erected to keep them at bay.   But, as I will demonstrate, there is no danger that a new financial instrument will threaten the sufficiency of truly principles-based standards.

First, the Co-Co liability –and for that matter all other financial instruments other than common shares—would be measured at an investor's replacement cost. (Thus, no inactive markets problem for determining the exit price; even if there are no current buyers, there are always sellers for the right price.)

Second, any changes in replacement cost are to be reported through net income.

Third, upon conversion, I would derecognize the Co-Co, increase paid-in capital for the market value of common stock immediately prior to the conversion, and record any difference in these two amounts in equity through net income. That's the amount that the holders of basic ownership interests gained or lost when the government pulled the trigger on its conversion option.

Any questions? I have one: when is the FASB going to adopt some principles? Also, any and all changes that would make the Codification easier to read would be much appreciated!

Off Topic  -- Tom on the Hot Seat

I had the honor of responding to questions from participants in a recent hour-long FASRI Roundtable dubbed "Perspectives on Standard Setting."  You can listen/watch a Second Life recording of my being grilled by some really smart folks slinging some really tough questions here.

Comments

[Tammy Buck]

Tom - Who is going to purchase these convertible securities? In other words, how is the distressed bank going to come up with the cash? Someone in the market place has to be willing to buy these securities, right? Or am I missing something important?

thanks, Tammy

[The Accounting Onion]

Tammy,

Co-Co's will be issued when a bank is healthy. The bank will have to offer a higher interest rate than straight debt, so it will increase the cost of doing business.

Conversion of the Co-Co reduces the probability of bankruptcy, because the bank no longer has to pay any of the debt service.

Let me know if this answers your question.

Best,
Tom

[David]

In your example, where the company has outstanding common stock, common stock call options and Co-Co debt, is it really accurate to say that the accounting treatment of the calls and the Co-Cos differ for no good reason? The call options can only be settled by delivery of common stock, while the Co-Co debt, depending on the course of future events, may be settled either by delivery of cash (at maturity, assuming no conversion) or by delivery of common stock upon conversion to equity. In that sense, do the Co-Cos really differ from any other convertible debt instrument, where the holder has the option of converting or not converting and receiving repayment of principal at maturity? In the case of the Co-Cos, the conversion decision may be out of the control of the holder of the debt, but until conversion is triggered, the debt can be settled in cash.

Thanks, David

[Accounting Onion]

Hi, David:
To my way of thinking, the income statement is for portraying the earnings available to the existing common shareholders. That's why interest is an expense (and, incidentally, dividends to preferred shareholders should be). Neither the Co-Co holders or the options holders are current common shareholders. When the shareholders win, all other financial stakeholders lose, and vice versa.

I hope that explains why in terms of classification of the right side of the balance sheet, to me there is common stock -- and everything else.

[Steve]

Hi Tom,

Good discussion at the round table. I share your outrage at the push by Big 4 to adopt IFRS in US.

One area that few people talk about when debating whether IFRS is "high quality" is exactly the "QUALITY" of the IASB board members.

IASB is definitely "high quantity" (15 members), but the "QUALITY" is far from being "high".
One can easily tell that when listening to their discussions at the public meetings. Take the liability-equity project, hedge accounting among others, some of the board members make one wonder if they even understand the subject well.

I understand that some of them are likely political appointees (based on the amount of contributions from particular region). But how could one write "High Quality" standard if the board members themselves display lack of decent knowledge in the subject matter?

John Smith, one of the few knowledgeable IASB board members, in an intereview Deloitte, admitted that the increasing size of the board is not equal to increasing quality of the board. I'd say that the opposite is probably true with IASB.