While I agree with the board on this issue, I have to wonder why managers didn't do this in the first place. Further, if we actually move toward a principles-based accounting, will investors and creditors ever be able to trust managers to implement these principles?

In an earlier column, I described some of the basic features of CoCos and discussed the disclosure by Juniper Networks. The economics of these types of bonds is relatively straightforward. By providing the conversion feature, investors will agree to a lower return on the instrument. Of course, the contingency feature makes it more difficult to value, but corporate executives seem to have no trouble handling these details. (Needless to say, anybody who can value a contingently convertible bond should be able to value the simpler stock options, but that is another story!)

A weightier matter is the accounting for CoCos themselves, and it appears that international accounting rules are better than the current FASB standards. In particular, IFRS 2 suggests that a CoCo be treated as a compound financial instrument. While FASB appears to be heading in that direction, considering Statement No. 150, the board actually has to study the issue and publish a standard on it. (One reader of this column mentions that under IFRS 2 and SFAS 123 the conversion feature appears to meet the definition of a share-based payment to a non-employee as long as you consider interest a good or service. That presents some interesting problems that the board might want to address!)

The issue at hand is how to treat CoCo bonds when calculating earnings per share. Currently Statement No. 128 says that the company can ignore the impact of the conversion feature whenever the convertibility depends on some contingency. It appears that the Emerging Issues Task Force proposes to overturn this aspect of Statement No. 128 and require corporations to include these securities in the computation of EPS. FASB is now studying the issue and we await the board's decision.

The business press buzzes with discussion of this possible accounting change and its consequence on corporate financial statements and on the desirability of continuing to employ these securities. The Wall Street Journal, for example, reports that 84 percent of this year's issuance of convertible bonds included a contingency in its offer. It reports that the earnings per share of several firms will be impacted, including General Motors, Omnicom, Serena Software, and others. The shock at General Motors probably exceeded that of other firms inasmuch as the price of its common stock dropped five percent when the news of the possible new FASB rule became public. Other firms that could suffer include Lear, American Axle, and Merrill Lynch.

For me, two fundamental questions arise from this murmuring. The first set of questions concerns why the stock price of General Motors declined, since the economics of the corporation has not changed one iota. The possible new accounting standard by FASB does not affect the interest rate of the security, it does not disturb the convertibility feature, and so it has no impact on the cash flows of General Motors. Presumably, the stock market is inefficient with respect to the economics of a CoCo (or the market found it too costly to explore the economics of CoCos). So I muse -- did the managers hope for market inefficiency by receiving funds from bondholders with no ill effects on their stock prices, even though CoCos have some probability of reducing EPS? Did these executives issue these instruments for their low interest rates or did they issue them for their accounting effects? My money is on the latter because of the scuttlebutt that the CoCo market may dry up if FASB actually issues a rule on this matter.

The second issue concerns principles-based accounting. Given the fact that FASB has a flawed rule in Statement No. 128 and that it is now correcting its error, would a principles-based approach constitute an improvement? I doubt it. First, what would a principles-based standard on CoCos look like? It would either be specific and provide some guidelines, or it would rely on some general principles. If specific, such as Statement No. 128, there wouldn't be much of a difference between a rules-based and a principles-based system. On the other hand, a principles-based standard could rely on some ambiguous platitude that would permit corporations much latitude on how to account for the transactions and whether to incorporate such bonds in the computation of earnings per share. Given the present paucity of useful disclosures about CoCos, I don't see much improvement that could occur in principles-based accounting.

During the period of the accounting scandals, I often said that principles-based accounting requires principled individuals, and I don't know whether we have enough principled managers to make it work. Even though the scandals have abated somewhat, I'm inclined to hold on to that position. After all, some executives and their Wall Street advisors still seem to treat their capital customers poorly.

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle for SmartPros.com.