Office of the Chief Accountant:
Letter from Chief Accountant to EITF on Accounting for Convertible Securities with Beneficial Conversion Features

July 16, 2001

Mr. Timothy S. Lucas
Director of Research and Technical Activities
Financial Accounting Standards Board
401 Merritt 7
P.O. Box 5116
Norwalk, CT 06856-5116

Dear Mr. Lucas,

The Emerging Issues Task Force (EITF) has been working on Issue No. 00-27, Application of EITF Issue No. 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to Certain Convertible Instruments, since last September. The staff understands that numerous practice issues have arisen since Issue 98-5 was issued that led the EITF to add this issue to its agenda. However, the staff believes that Issue 00-27 does not provide clear and transparent guidance. The staff is concerned that the EITF's conclusions reached and other tentative guidance being developed are overly complex and will not result in guidance that can be easily understood and consistently applied by preparers and auditors on a comparable basis.

The economics of many of these instruments is that they are simply a bridge financing for a period of time. The beneficial conversion is embedded in the terms of the financing as part of the cost of the financing. Both the investor and investee make an estimate of the value of this component of the financing in calculating their overall return or cost from the transaction. Accordingly, investors and the EITF would be better served if the fair value of the beneficial conversion was measured at the date of issuance, and charged to expense consistent with other types of financing costs. Further, the EITF should limit the scope of Issue 00-27 to those issues that are pervasive in practice where application of Issue 98-5 is unclear. Additionally, we believe the EITF should clarify the language and examples and include the underlying rationale for the conclusions reached. As part of this process, the EITF should consider the following:

• Calculating the beneficial conversion feature at the issue date. While the EITF has changed Issue 98-5's commitment date model to one that is based on FASB Statement No. 133's definition of a firm commitment, it has also stated that a material adverse change clause creates optionality, precluding a commitment date before the security's issuance. Given that many agreements have such clauses, one alternative the EITF should consider is simply requiring the beneficial conversion amount to be calculated at the issue date. This change will help to eliminate future practice issues.

• Accreting the beneficial conversion feature from the date of issuance to the earliest conversion date. The accretion of the beneficial conversion amount should be recognized over the earliest period that the security holders can realize that return. This concept was established in EITF Topic D-60 and retained in Issue 98-5, but was changed by the EITF in Issue 00-27. This concept is a basic element of the model, and should not be changed. To eliminate future confusion on this issue between the different positions and consensuses, the EITF should retain this provision in Issue 00-27.

• Requiring pay-in-kind (PIK) instruments be measured at fair value. The accounting issues for PIK instruments can be complex. The staff questions, however, whether these accounting issues are pervasive in practice, and whether the EITF's detailed guidance is understandable to preparers of financial statements and those auditors that are not technical specialists. PIK instruments issued as dividends should be recorded at fair value, and the EITF should develop an understandable model for any related PIK issues that it believes should be addressed through this consensus.

• Use of fair value. Issue 00-27 continues to expand on the book value model established in Issue 98-5, instead of fully exploring the use of fair value to measure beneficial conversion features. The staff shares the concern that others have about the reliability of fair value estimates, particularly in transactions with contingencies. However, the staff believes that the EITF should incorporate fair value measurements into the Issue 00-27 model, and provide guidance as to how fair value estimates can be made reliably.

The staff hopes that the EITF will address these items and develop a plan to timely address only those remaining issues that are pervasive in practice, drafting a complete and understandable consensus with illustrative examples, as appropriate. If you have any questions, please contact Jackson Day, David Kane, or me at (202) 942-4400.

Sincerely,

Lynn E. Turner
Chief Accountant

http://www.sec.gov/info/accountants/staffletters/eitf071601.htm