Thread by @drinkthecoffee2

Thread on the OCF line item “Operating cash flow related to repayment of discounted convertible notes” from $TSLAs Q1 letter that zach was kind enough to provide. This item deducted $188.1M from OCF and no explanation was given. Anyone know whats going on? $TSLAQ 1/

This deduction from OCF raises the question: did $TSLA recognize $188.1M of non-cash income on the I/S? Looking through the applicable guidance, I did not see an obvious basis for an I/S impact from the debt repayment, but I also did not see a basis for an OCF impact. 2/

These convertible bonds are considered to be a hybrid instrument with an embedded conversion option. Oddly, the OCF line is the exact amount recorded in the 10k for the embedded conversion option. My understanding of how to account for the embedded conversion option: /3

first you look at whether the option should be accounted for as a derivative, in which case it must be “bifurcated” and recorded as an asset or liability unless subject to an exception. Here, yes, but an exception applies. /4

next you look at whether there are applicable exceptions to derivative treatment. The potential exception here is for instruments that are (a) indexed to the issuers own equity and (b) eligible to be recorded in shareholders equity. /5

These rules are aimed at excluding instruments w/ required net cash settlement or not tied to the issuers equity. (b) is more complicated here and has 7 factors (see ASC 815-40-25-10) aimed at whether the issuer can be required to net cash settle in any circumstance. /6

there is some potential uncertainty, but equity classification seemed correct to me. Notably, these factors should be reassessed continuously to determine if the instrument must be reclassified as a derivative bc it fails the exception. /7

If so, the instrument is reclassified (from equity as additional paid in capital) at its then current fair value as a liability, and changes in value afterward are reflected in earnings. /8

embedded features in converts that are not bifurcated, ie pass the test above, are assessed as either “conventional convertible bonds” or under the cash conversion guidance. Practically nothing counts as conventional, because that would be too easy. /9

Here, it is the feature that allows settlement in a combination of cash and stock. cash conversion guidance tells you to separate the embedded option from the debt. The fair value of equivalent *non convertible* debt is determined to record the value of the debt piece. /10

The difference between the face amount of the debt and this fair value is attributed to the option. The discount created on the debt in this fashion is amortized over the life of the instrument as the cost of debt and the carrying value of the debt is adjusted accordingly. /11

$TSLA’s historical accounting treatment of both pieces is consistent with the cash conversion guidance. The option is booked in equity as additional paid in capital and carried at the initial value as long as it qualifies for equity treatment (per above). /12

If that changes at any time, the option is reclassified as a derivative and booked as a liability as noted above. when the instrument matures, any difference between the current carrying cost of the debt and the amount paid to holders is recorded as income/loss. /13

Because the discount amortized over the life of the debt is added to the carrying value, the carrying value and repayment of par should converge at maturity and would not result in any income/loss. /14

The option portion is then treated as if the issuer repurchased the equity recorded as the option without any income statement impact. /15

Any smartish folks out there have any idea why we are seeing an OCF deduction from the convert repayment? I tried calling zachary but it went straight to VM… /16
cc @markbspiegel