In some cases, convertible debt is issued on a stand-alone basis and it is readily apparent that there is only one unit of account. In other financing transactions, convertible debt is issued with detachable warrants or other derivatives intended to offset share dilution. If these other instruments are legally detachable and separately exercisable, they must be accounted for separately from the convertible debt in accordance with other applicable US GAAP. An entity must appropriately allocate the proceeds to each separate unit of account.

To select an appropriate accounting model, an entity must first consider whether the embedded conversion feature requires separate accounting as a derivative liability. It must also consider whether other embedded features in the instrument (e.g., put or call options, interest rate adjustments) require separate accounting as derivatives. The allocation of proceeds to a convertible debt instrument may affect whether an embedded derivative feature requires bifurcation.

The evaluation of whether an embedded conversion option requires separate accounting as a derivative liability is performed in accordance with ASC 815; it can be time-consuming and complex. The more unique the terms of a convertible debt instrument, the more likely that the embedded derivative requires bifurcation. The embedded conversion option will require separate accounting as a derivative liability if there are nontraditional adjustments to the conversion rate (e.g., certain make-whole features) or the issuer does not control the ability to settle the conversion option in its common shares.

If the embedded conversion option does not require bifurcation, the entity must consider whether the CCF, BCF, or substantial premium guidance applies. This determination, and the application of this guidance, can be difficult and may require the assistance of accounting advisers. Only if the convertible debt instrument is not within the scope of the CCF, BCF, or substantial premium guidance is the instrument accounted for as a single liability in accordance with the accounting model for traditional convertible debt. See below for further discussion of the accounting models that apply to convertible debt.

The subsequent measurement of convertible debt depends on which accounting model applies. For example, if the conversion option must be accounted for as a derivative instrument, the entity must periodically measure its fair value in accordance with ASC 820, which may require a complex valuation model. In addition, the periodic calculation of interest cost under the interest method will be affected by the amount of proceeds allocated to the convertible debt instrument and the accounting model applied. While some interest calculations are relatively simple, others may be quite complex (e.g., convertible debt with a CCF or BCF). In general, an entity does not subsequently remeasure an equity component that is separately recognized under the CCF, BCF, or substantial premium model.

The balance sheet classification of convertible debt as either current or long term also depends on the accounting model applied to the instrument. Entities may unexpectedly need to reclassify an instrument’s liability component as a current liability on the basis of the investor’s ability to convert the instrument (e.g., if the principal amount would be settled in cash upon conversion).

A modification of a convertible debt instrument may represent an extinguishment or require an amount to be recognized in equity. It may also change the accounting model that is applied. Settlements are complex because they may be reflected as extinguishments or conversions depending on the circumstances. Some settlements may reflect induced conversions, which require special accounting considerations.

ASC 470-20 specifies the disclosures required for convertible debt. The nature of the required disclosures depends on which accounting model is applied. In addition, the disclosure requirements in other GAAP—such as ASC 405-10, ASC 505-10, ASC 815-10, ASC 815-40, and ASC 820—may apply, depending on which accounting model is applied to a convertible debt instrument.

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 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.

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.