'CoCo' Rule Change Could Threaten Profits

If the Financial Accounting Standards Board has its way, corporate earnings will face yet another headwind in the second half of the year.

In recent weeks, stocks have fallen sharply on concerns that profit growth is about to slow down. Companies are facing a number of challenges in the third and fourth quarters, including higher oil prices, rising interest rates and tougher comparisons to last year.

While analysts are fully aware of these issues and have been lowering their expectations for the fourth quarter, it's possible that these estimates will have to be revised down further if a proposed accounting rule is adopted by the FASB in December.

The FASB, a private body that sets accounting guidelines, said last week that it wanted to standardize the accounting treatment for straight convertible bonds and contingent convertibles, a move that could reduce earnings at some companies by as much as 19% this year.

Contingent convertible bonds, or CoCos, are similar to straight convertible bonds in that they have a strike price at which the investor can convert the bond into stock. The difference, however, is that CoCos can't be converted until a contingency requirement is met. Some companies, for example, might require the stock to trade at 110% of the conversion price for 20 out of 30 trading days.

More importantly, while straight convertible bonds dilute earnings as soon as they are issued, contingent convertibles do not.

Companies must account for straight convertible bonds as if they had been converted into stock on the day of issuance. This increases shares outstanding and lowers earnings per share. But issuers of contingent convertibles are not required to increase their share count or dilute their earnings until the contingency requirement is met. The FASB is hoping to change that.

If that move is successful, some companies will be hit hard. General Motors(GM Quote - Cramer on GM - Stock Picks), for example, could see 2004 earnings shaved by 17.3% in 2004 and 17.4% in 2005, according to David Bianco, head of the valuation and accounting group at UBS Investment Research.

CenterPoint Energy (CNP Quote - Cramer on CNP - Stock Picks) could see profits shrink by 12% this year and next, while Comverse Technology(CMVT Quote - Cramer on CMVT - Stock Picks) could see an 11% reduction in earnings per share. Omnicom Group (OMC Quote - Cramer on OMC - Stock Picks) would see earnings decline by more than 10%.

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