Comments
Companies that raised funds through foreign currency convertible bonds (FCCB) are finding it difficult to repay the bonds— and it’s not only the loss-making companies, but even those making profits.
The interest rate on an FCCB is generally lower compared with a loan. Investors are okay with the lower interest as they expect to be compensated by equity gains.
At the time of buying FCCB, the investors enter into an agreement with the seller to convert the shares at a pre-determined price with a lock-in period. Equity gains are realised when the share price exceeds the pre-determined price at the time of conversion.
The current accounting treatment is to charge the interest expense to profit or loss based on the coupon interest rate, which is usually lower than a loan interest rate.
No accounting is required to arrive at profit for the year for the option to convert FCCB into equity shares. The lower interest expense boosts the company’s profits, thereby creating a situation that is far from reality.
For example: Company Alpha has borrowed Rs 1,000 crore by issuing FCCB. The coupon interest is 2 per cent, and the term of FCCB is five years. The company’s profit or loss over the term is as shown in Table 1.
The company reports increasing profit every year, indicating growth. At the end of the term, the FCCB holders decide not to convert the bonds, and want to redeem for Rs 1,000 crore. The company explores the option of financing the FCCB through a bank loan at a prevailing interest rate of 12 per cent per annum. The company prepares a projection for the next five years (Table 2).
Although the company’s revenues and profits increase every year, it does not have the capability to service the interest obligation on the entire Rs 1,000 crore. The average profits before interest over the next five years will be Rs 87 crore. With an interest rate of 12 per cent, the company can only service the debt of around Rs 700-750 crore. It has little hope of raising capital by way of equity shares — even if it reduces the debt levels by Rs 250-300 crore, it is not in a position to offer any returns to equity shareholders.
The reason is that the lower interest expense accounted for in the initial years did not reflect the true profitability of the company.
The earnings per share (EPS) disclosures required by the accounting standards are also not very helpful. It only addresses the shareholders’ earnings in a situation where FCCBs are converted into equity shares, and not where the FCCB holders decide not to convert.
Under other accounting frameworks such as International Financial Reporting Standards, the interest expense in the profit or loss statement should represent the interest rate on a pure loan, and not the coupon rate on FCCB. This treatment ensures that the economics of the transaction is appropriately reflected in the financial statements.
As convergence with IFRS seems uncertain, regulators should consider an accounting treatment that reflects business realities more accurately. An investor may be completely unaware of the realities during the first five years. The sharp increase in interest costs, resulting in significantly depressed profits or even a loss, may severely erode an investor’s wealth.
Rahul Chattopadhyay is Partner, Price Waterhouse
Ashish Taksali, Senior Manager, contributed to the article.
Comments
COMMENT NOW
Comments
Comments have to be in English, and in full sentences. They cannot be abusive or personal. Please abide by our community guidelines for posting your comments.
We have migrated to a new commenting platform. If you are already a registered user of TheHindu Businessline and logged in, you may continue to engage with our articles. If you do not have an account please register and login to post comments. Users can access their older comments by logging into their accounts on Vuukle.