ASC 470-20: Accounting for Debt with Conversion Features
Learn how ASC 470-20 requires separating convertible debt proceeds into liability and equity, impacting interest expense and carrying value over the term.
Accounting Standards Codification (ASC) 470-20 provides the authoritative guidance for debt instruments that include options for conversion into an issuer’s stock. The primary objective of this standard is to ensure that the economic substance of these hybrid instruments is appropriately reflected in the financial statements. Recent updates have simplified the accounting for convertible instruments, eliminating the previous requirement for most to be separated into debt and equity components at issuance.
Scope of Debt with Conversion Features
The guidance in ASC 470-20 applies to debt instruments that are convertible into the issuing company’s own stock. This includes a variety of financial instruments, such as convertible bonds or convertible preferred stock that is classified as a liability. The core feature that brings an instrument within this scope is the holder’s ability to exchange the debt for a specified number of equity shares.
However, there are explicit exceptions to the scope of ASC 470-20. The guidance does not apply if the convertible instrument is accounted for at fair value, with changes in fair value reported in earnings, under the fair value option of ASC 825. Additionally, if an embedded conversion feature must be separated and accounted for as a derivative under ASC 815, the instrument is not accounted for under ASC 470-20.
Another exception relates to convertible preferred stock that is properly classified as equity. The standard also carves out an exception for debt where the only cash settlement relates to paying cash in lieu of issuing a fractional share upon conversion.
Initial and Subsequent Accounting
Under the simplified guidance, a convertible debt instrument is accounted for as a single liability unit. When the debt is issued, the proceeds are recorded as a liability, and there is no separation of an equity component at inception. This approach treats the instrument as a whole, rather than bifurcating the value of the conversion feature.
After issuance, any discount or premium on the debt is amortized as interest expense over the life of the instrument. This is done using the effective interest method, which results in a constant rate of interest being applied to the debt’s carrying amount each period.
Accounting for Settlement and Extinguishment
The final stage in the accounting for convertible debt involves its settlement, which can occur through several different events. The accounting treatment varies depending on whether the debt is converted by the holder, repaid at its scheduled maturity, or extinguished early through a repurchase.
When an investor chooses to convert the debt into stock according to the original contractual terms, the company derecognizes the carrying value of the bond and issues the shares. No gain or loss is recognized upon a standard conversion. The accounting entry involves removing the bond payable at its carrying amount, with the offset credited to common stock and additional paid-in capital.
If the debt is not converted and is held to its maturity date, the settlement is a straightforward extinguishment. By this point, any initial discount or premium should have been fully amortized, meaning the carrying value of the bond is equal to its face value. The journal entry simply involves debiting the Bonds Payable account and crediting Cash for the amount paid.
An early repayment or repurchase of the debt before its maturity date is also treated as an extinguishment. A gain or loss is calculated as the difference between the debt’s carrying value on the date of repurchase and the amount of cash paid to extinguish it.
Financial Statement Disclosure Requirements
Companies with debt instruments falling under ASC 470-20 must provide specific information in the notes to their financial statements. The required disclosures include the material terms and features of the conversion option. This involves detailing how the debt can be converted, the conversion price or rate, and any conditions that could alter these terms.
Furthermore, the company must disclose the carrying amount of the debt on the balance sheet, clearly distinguishing it from other liabilities. The disclosures must also include the effective interest rate on the liability for the reported periods.