ASC 470-20: Accounting for Debt With Conversion Options

Accounting Standards Codification (ASC) 470-20 provides the framework for how companies should account for debt that includes options for conversion into company stock. The guidance has evolved, most notably with Accounting Standards Update (ASU) 2020-06, which simplified the previously required accounting treatments. Before this update, companies often had to separate the value of a conversion feature from the debt itself. The current rules streamline this process, treating most convertible debt instruments as a single, unified liability, which makes the resulting financial statements more consistent.

Scope and Recognition Models

The applicability of ASC 470-20 extends to two primary categories of financial instruments: debt with an embedded conversion feature (convertible bonds) and debt issued with detachable stock purchase warrants. A convertible bond gives the holder the right to exchange the debt for a set number of the company’s shares. Debt with detachable warrants includes a standard debt instrument and separate, tradable warrants to purchase company stock.

A foundational change from ASU 2020-06 was the elimination of several accounting models for most convertible instruments. Previously, accountants had to assess convertible debt for features that required separating the conversion option’s value from the debt and recording it as equity.

Under the simplified guidance, this separation is no longer required for the majority of convertible instruments. The new approach treats a convertible debt instrument as a single liability. Upon issuance, the entire value of the instrument is recorded as debt, without carving out a separate amount for the equity-based conversion option. This unified liability model is now the standard approach for convertible notes and bonds within the scope of ASC 470-20.

Initial Measurement and Accounting

The initial recording of a debt instrument under ASC 470-20 establishes its carrying amount on the balance sheet, with the accounting treatment depending on the instrument’s structure. The guidance provides distinct paths for debt issued with detachable warrants versus standard convertible debt.

Debt Issued with Detachable Warrants

When a company issues debt with detachable stock purchase warrants, ASC 470-20 requires allocating the cash proceeds between the debt and the warrants based on their relative fair values at issuance. Because the warrants are separate equity-linked instruments, the portion of proceeds allocated to them is recorded in additional paid-in capital. This allocation results in the debt being recorded at a discount.

For example, a company issues a $1,000,000 bond with detachable warrants. The bond’s fair value is $970,000, and the warrants’ fair value is $30,000. The $1,000,000 in cash proceeds would be allocated with $970,000 to the debt and $30,000 to the warrants. The journal entry would debit Cash for $1,000,000, credit Bonds Payable for $1,000,000, debit Debt Discount for $30,000, and credit Additional Paid-in Capital—Warrants for $30,000.

Convertible Debt Instruments

The accounting for convertible debt instruments was the primary area of simplification under ASU 2020-06. For most convertible bonds, the entire instrument is accounted for as a single liability at its issuance price. The conversion feature is not given a separate value in the equity section of the balance sheet at inception.

If a company issues a $1,000,000 convertible bond for $1,000,000 in cash, the journal entry is a debit to Cash for $1,000,000 and a credit to Bonds Payable for $1,000,000. No portion of the proceeds is allocated to equity, and no debt discount is created from separating the conversion feature. The full amount is attributed to the liability.

Subsequent Measurement and Amortization

After initial recording, the accounting focus shifts to the ongoing measurement of interest expense. For instruments recorded with a discount or premium, this process requires the systematic amortization of that amount over the instrument’s life.

The primary mechanism for this is the effective interest method. This method calculates interest expense by applying a constant effective interest rate to the debt’s carrying amount at the beginning of each period. The difference between the calculated interest expense and the cash interest paid represents the amortization of the discount or premium.

Using the earlier example of debt with detachable warrants, the company recorded a $30,000 debt discount. Assume the bond has a 5-year term, pays 6% annual cash interest ($60,000), and the effective interest rate is 6.76%. In the first year, interest expense is $65,572 ($970,000 initial carrying amount x 6.76%). The company pays $60,000 in cash interest, so the $5,572 difference is the discount amortization.

The journal entry to record this is a debit to Interest Expense for $65,572, a credit to the Debt Discount for $5,572, and a credit to Cash for $60,000. This entry increases the debt’s carrying amount. This process repeats annually until the discount is fully amortized and the carrying amount equals the debt’s face value at maturity.

Accounting for Conversion or Extinguishment

The final stage for a convertible debt instrument is its settlement, which occurs through either conversion into equity or extinguishment via repayment.

Conversion of Debt

When a holder converts debt into stock, the accounting uses the book value method, and the company does not recognize a gain or loss. The carrying amount of the debt at the conversion date is reclassified from a liability to equity. This amount includes the debt’s face value adjusted for any unamortized premium, discount, or issuance costs.

For instance, if a $1,000,000 convertible bond with a carrying amount of $980,000 is converted, the accounting entry removes the liability. The company would debit Bonds Payable for $1,000,000, credit the unamortized Debt Discount for $20,000, and credit Common Stock and Additional Paid-in Capital for the combined $980,000. This entry transfers the liability’s book value to the equity section.

Extinguishment of Debt

If debt is retired or repaid before maturity and is not converted, the transaction is a debt extinguishment, and the company recognizes a gain or loss on the income statement. The gain or loss is the difference between the reacquisition price and the net carrying amount of the debt on the extinguishment date.

For example, a company repurchases a convertible bond with a $1,000,000 face value and a $990,000 carrying amount. If the company pays $1,005,000 to retire the debt, it recognizes a loss on extinguishment of $15,000 ($1,005,000 paid less $990,000 carrying amount). The journal entry would debit Bonds Payable for $1,000,000 and Loss on Extinguishment for $15,000, and credit the unamortized Debt Discount for $10,000 and Cash for $1,005,000.

Disclosure and EPS Impact

Proper accounting for convertible debt requires transparent reporting in financial statements and notes. ASC 470-20 mandates disclosures to help investors understand the instruments, including key terms like the conversion price, maturity date, and interest rate. Companies must also disclose the debt’s carrying amount and the effective interest rate for instruments with a discount or premium.

The existence of these instruments also affects a company’s reported Earnings Per Share (EPS), as they represent potential dilution for existing shareholders.

EPS Impact

The if-converted method, required by ASC 260, is used to incorporate the effect of convertible debt into diluted EPS. This method assumes the debt was converted into common stock at the beginning of the reporting period or at issuance, if later. Applying this method requires adjusting both the numerator and the denominator of the basic EPS calculation.

For the numerator, the company adds back the after-tax interest expense associated with the debt, as this interest would not have been paid upon conversion. For the denominator, the company adds the number of common shares that would have been issued if the debt had been converted. This calculation is only performed if the result is dilutive; if including the shares would be antidilutive by increasing EPS, the conversion is not assumed.