Replies to post #33074 on Total Sports Media Inc. (fka TSMI)

[PhantomRecce]

Continuing my research, here's some more information on FASB Accounting Rules governing reporting of Derivative Assets and Liabilities that are associated with Convertible Debentures.

The following sections from the FASB Accounting Rules on Convertible Debt paper tells us everything we need to know about why the company had to show the ~$5 million in Derivatives Liability... and how that $5 million figure can be reduced and extinguished over time.

More importantly, the paper makes it clear the accounting of fair value interest expense for Convertible Debentures does not in of itself change the material value of the company, or its share price, or its borrowing costs.

Issuers contemplating a financing should take note of new accounting guidance affecting certain convertible securities. Cash-settled convertible bonds have been a popular means of financing for issuers because the issuance of these bonds had a less dilutive effect on earnings per share than did the issuance of other securities. However, in May 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (“FSP”) APB 14-1,1 which requires issuers to separately account for the liability and equity components of convertible debt instruments that may be settled partially or wholly in cash.
~~~~~~~~~~~~~~~~~~~~
As we discuss below, application of this accounting standard may cause issuers to favor other securities over cash-settled convertible debt instruments, may motivate issuers and financial intermediaries to structure convertible securities differently, and may serve as a catalyst for restructuring existing transactions.
Scope
~~~~~~~~~~~~~~~~~~~~
The FSP applies to convertible debt that may be partially or wholly cash-settled upon conversion and to convertible preferred shares that are mandatorily redeemable financial instruments classified as liabilities under FASB Statement No. 150.
~~~~~~~~~~~~~~~~~~~~
Under the new rules, an issuer must separately account for the liability and equity components of a convertible debt security. The issuer must value the liability component by measuring the fair value of a similar straight (nonconvertible) debt security.
~~~~~~~~~~~~~~~~~~~~
An issuer must compute the carrying amount of the equity component of the convertible instrument by deducting the value of the liability component from the initial proceeds received at issuance. The equity component should be recorded as additional paid-in capital on the issuer’s balance sheet. The issuer then must allocate transaction costs proportionately between the liability and equity components. This new bifurcated approach may result in the liability component having a temporary basis difference for income tax purposes. The FSP requires that this difference be recorded as an adjustment to additional paid-in capital.
~~~~~~~~~~~~~~~~~~~~
An issuer must amortize over the expected life of the debt security, using the interest method, the excess of the initial proceeds over the initial fair value of the debt component (referred to as the debt discount) and issuance costs. This means that in subsequent periods the issuer must recognize non-cash interest expense in addition to the cash payments made on the debt security. Because the debt discount is amortized, the amount of interest expense reported in each subsequent period will be greater than an issuer would have previously recognized under GAAP. In determining the expected life of the debt security, the issuer should ignore the conversion option and should consider other substantive prepayment features to ensure that the assumptions used in the amortization calculation are the same as those used in the valuation calculation. As long as the equity component qualifies as equity under GAAP, subsequent measurement is unnecessary.

If an instrument is (1) converted, (2) paid off, or (3) modified or exchanged in such a way that qualifies as extinguishment under GAAP (referred to as derecognition), the issuer must allocate the consideration to the extinguishment of the liability component and (y) the reacquisition of the equity component.

Given the new accounting treatment, an issuer may look to modify the terms of existing convertible debt securities to avoid the higher interest expenses. The FSP would not apply to the modified security prospectively, however, if the modification occurred before the FSP’s effective date, the issuer would have to apply the FSP retrospectively up to the modification date.
~~~~~~~~~~~~~~~~~~~~
New FASB Accounting Rules on Convertible Debt
Impact
Application of the FSP will have the primary effect of making certain convertible debt instruments less attractive financing options for issuers. The FSP closes a perceived loophole that permitted an issuer to account for a convertible debt instrument only as debt on its financial statements. Now, an issuer will be required to recognize non-cash interest expense that reflects the amounts the issuer would have had to pay if the instrument did not have the conversion option. This, in turn, results in increased interest expense that lowers an issuer’s earnings per share. The FSP has eliminated the favorable accounting treatment that helped make convertible debt instruments attractive.

The FSP also may affect stock prices and perceptions regarding an issuer’s leverage. In principle, the new accounting should not affect an issuer’s stock price because the fundamental economics underlying the convertible debt security remain unchanged. If, however, investors perceive the accounting changes as reflecting higher borrowing costs for the issuer, there may be downward price pressure on the issuer’s securities.

Prior to the FSP, an issuer would recognize as debt on its balance sheet the full amount of the initial proceeds of issuance. Because the FSP requires bifurcation, the actual principal amount of debt that an issuer is carrying may be understated on its balance sheet. Under the FSP, issuers only recognize as debt the liability component of the convertible debt security.

Here's the bottom line: the FASB rules on accounting for Convertible Debt Instruments forces a "Fair Price" basis of the convertible shares as interest payments they would incur if they didn't have the Convertible Shares Option, artificially inflating expenses on the company's Balance Sheet.

In other words, the Derivatives Liability does not represent an actual cash expense for the company; but, rather, it forces the company to display a "non-cash" Interest Expense depicting the amount of interest liability they would have incurred under other types of financing options. As a result, the FSB requirement to show this interest expense reduces the company's earnings per share on their Balance Sheet.

This accounting requirement does not imply the company cannot obtain favorable terms and interest payments on future borrowing. That is something investors and funders need to decide for themselves, based on the strengths and weaknesses of the company's business model, revenues and costs.

AIMO, of course.