Breaking down accounting for convertible debt issuers

Convertible debt 101

An entity raising capital by issuing a convertible debt instrument must apply complex financial reporting requirements in US GAAP. To properly account for such an instrument, an entity must consider the following:Entities often issue convertible debt because it has a lower interest cost than other debt instruments. For example, if an entity is in the growth stage of its life cycle and expects its common stock to increase in fair value, it may issue convertible debt after considering the cost of capital, potential share dilution, and investor demand.

In some cases, an entity may issue convertible debt and simultaneously enter into derivatives (e.g., purchased or written call options on its common stock) to offset the potential share dilution that will occur if the debt instrument is converted into common stock. Although such derivatives generally raise the cost of capital, it may still be more favorable for the entity to issue a combination of convertible debt and derivatives than to issue nonconvertible debt (e.g., lower overall cost of capital or favorable tax benefits). When an entity issues freestanding derivatives on its common stock, the financial reporting and compliance risks increase because of the need to apply complex, rules-based accounting guidance to these instruments. Entities should ensure that they have the appropriate internal controls in place to properly account for and disclose convertible debt instruments and any related derivatives.

Questions to consider

ASC 470-20 provides general guidance on the accounting for convertible debt. However, numerous other sections in US GAAP must also be considered. While the relevant accounting guidance has existed for a number of years, it will change significantly upon an entity’s adoption of ASU 2020-06, which amends US GAAP to eliminate the cash conversion feature (CCF) and beneficial conversion feature (BCF) accounting models (see below for further discussion of the accounting models).

As noted above, to determine the appropriate accounting for convertible debt, entities must consider five key questions:

Accounting models for convertible debt

Under US GAAP before the adoption of ASU 2020-06, there are five different accounting models for convertible debt instruments that are issued in financing transactions:

Scope

• Convertible debt that does not contain a separated conversion option liability, CCF, BCF, or substantial premium.

Accounting: Single liability

• Initial accounting — Recognize the instrument as a single liability.
• Subsequent accounting — Recognize the liability at amortized cost if the fair value option (FVO) is not elected.

Compliance and financial reporting considerations

• Decreased reported interest cost.
• Increased liability amount on the balance sheet.
• Less complex accounting.
  

Scope

• Convertible debt that (1) does not contain a separated conversion option liability, CCF, or BCF and (2) is issued at a significant premium to the stated principal amount.

Accounting: Liability and equity component

• Initial accounting — Recognize (1) the premium as an equity component and (2) the remaining proceeds as a liability.
• Subsequent accounting — Recognize the liability component at amortized cost. The equity component is generally not subsequently remeasured.

Compliance and financial reporting considerations

• Increased reported interest cost.
• Decreased reported liability amount on the balance sheet.
• More complex accounting at inception only.
  

Scope

• Convertible debt that contains a conversion option that meets the definition of a derivative and either (1) is not indexed to the company’s stock or (2) may require cash settlement upon events or circumstances outside the issuer’s control.
  

Accounting: Two liability components

• Initial accounting — (1) Recognize the conversion option component at fair value and (2) allocate the remaining proceeds to the host liability component.
• Subsequent accounting — Recognize (1) the conversion option liability component at fair value, with changes recognized in earnings, and (2) the host liability component at amortized cost.

Compliance and financial reporting considerations

• Increased reported interest cost.
  
• Volatility in earnings because derivative liability is marked to market.
  
• Fluctuating aggregate liability amounts on the balance sheet.
  
• More complex accounting at inception and on an ongoing basis, including valuation of the conversion option.
  

Scope

• Convertible debt that (1) does not contain a separated conversion option liability and (2) allows the issuer to fully or partially settle a conversion in cash.
  

Accounting: Liability and equity component

• Initial accounting — Recognize (1) a liability for the fair value of a similar nonconvertible debt instrument and (2) the remaining proceeds in equity.
• Subsequent accounting — Recognize the liability component at amortized cost. The equity component is generally not subsequently remeasured.

Compliance and financial reporting considerations

• Increased reported interest cost.
  
• Decreased reported liability amount on the balance sheet.
• More complex accounting at inception and upon settlement of the instrument.
  

Scope

• Convertible debt that (1) does not contain a separated conversion option liability or CCF and (2) contains a conversion option that is in-the-money to the investor.

Accounting: Liability and equity component

• Initial accounting — Recognize (1) an equity component equal to the intrinsic value of the conversion option and (2) the remaining proceeds as a liability.
• Subsequent accounting — Recognize the liability component at amortized cost. The equity component is generally not subsequently remeasured.

Compliance and financial reporting considerations

• Increased reported interest cost.
• Decreased reported liability amount on the balance sheet.
• More complex accounting at inception and upon settlement of the instrument.

Continue your convertible debt learning

Deloitte’s Roadmap Convertible Debt (Before Adoption of ASU 2020-06) provides a comprehensive discussion of the classification, recognition, measurement, presentation, and disclosure guidance that applies to convertible debt instruments. This Roadmap will not be updated after 2023 because ASU 2020-06 is effective for all entities for fiscal years beginning after December 15, 2023. Entities that have adopted ASU 2020-06 should consider Deloitte’s Roadmap Issuer’s Accounting for Debt, which discusses the classification, initial and subsequent measurement, and presentation and disclosure of debt, including convertible debt.