Most guidance on convertible debt stops at issuance. The harder question for the auditor arrives later, when the note converts, is settled in cash and shares, or is repaid after the company offers the holders a sweetener. Each path has a different entry, and a wrong label means a gain, a loss or an expense that should not be there.
This guide picks up where the overview in /us/standards/asc-470-20-convertible-debt-asu-2020-06 ends. It covers the three issuance models in brief, then the settlement accounting with worked entries and the audit tests. For startup notes and SAFEs, see /us/blog/convertible-notes-and-safes-audit-for-startups.
What does ASU 2020-06 change?
ASU 2020-06 reduced the number of accounting models for convertible debt and convertible preferred stock, removed the beneficial conversion feature and cash conversion models, amended the derivative scope exception for contracts in an entity's own equity, and made changes to the EPS guidance. It is effective for fiscal years beginning after December 15, 2021 for SEC-filer public business entities that are not eligible to be smaller reporting companies, and for fiscal years beginning after December 15, 2023 for all other entities. Early adoption was permitted, but no earlier than fiscal years beginning after December 15, 2020, and an entity adopts as of the beginning of its annual fiscal year. Transition was modified retrospective or fully retrospective.
After the ASU, the issuance accounting follows one of three models, and the settlement accounting depends on which one applied:
- Single instrument. Record a liability equal to the proceeds. Amortize any discount or premium as for nonconvertible debt.
- Derivative separation. Carry the embedded conversion option at fair value, reduce the debt by the same amount, and run changes in fair value through income.
- Substantial premium. Record the debt at par and put the excess of proceeds over par in additional paid-in capital.
Does a conversion under the original terms create a gain or loss?
No. If a convertible instrument accounted for entirely as a liability converts under its existing terms, the conversion is not an extinguishment and no gain or loss is recognized. The carrying amount, including unamortized premium, discount and issuance costs, is reduced by any cash or other assets transferred, and the remainder goes to the capital accounts for the shares issued. This applies when the instrument is accounted for in its entirety as a liability, that is, the conversion option was not bifurcated as a derivative (ASC 470-20-40-4, as reproduced in ASU 2024-04).
An illustration. A $1,000,000 note has $19,000 of unamortized issuance costs. It converts under its terms into 100,000 shares with a $0.01 par value.
| Account | Debit | Credit |
|---|---|---|
| Convertible note payable | 1,000,000 | |
| Unamortized debt issuance costs | 19,000 | |
| Common stock (100,000 x $0.01) | 1,000 | |
| Additional paid-in capital | 980,000 |
The share price on the conversion date does not enter the entry. That is the check an auditor runs first: any entry that credits equity at the market value of the shares, or books a loss for the gap, is applying the wrong model.
What is an induced conversion?
An induced conversion occurs when the issuer offers a sweetener, such as a reduced conversion price, warrants or cash, to encourage conversion during a limited period. PwC says 30 to 60 days is generally a limited period, and the examples in ASU 2024-04 use offers open for 30 and 60 days; the Codification sets no fixed number. After ASU 2024-04, the criteria are:
- The offer is exercisable for a limited time.
- The settlement includes all consideration, in both form and amount, required by the existing conversion terms.
- The conversion option was substantive at issuance and when the offer was accepted.
When all three hold, the issuer recognizes an expense equal to the fair value of the consideration paid in excess of what the existing terms require. ASU 2024-04 was issued in November 2024 to improve the relevance and consistency of the induced conversion guidance, because the old guidance was written when convertible debt was mainly share-settled and cash convertible instruments raised questions. It is effective for all entities for annual periods beginning after December 15, 2025, including interim periods, and early adoption is permitted only for entities that have already adopted ASU 2020-06.
An illustration. The existing terms convert the $1,000,000 note, carried at $1,000,000 with no unamortized costs, into 100,000 shares. The company offers 110,000 shares for conversion within 45 days, and the holders accept when the stock is worth $10 a share. The 10,000 extra shares are worth $100,000.
| Account | Debit | Credit |
|---|---|---|
| Convertible note payable | 1,000,000 | |
| Induced conversion expense | 100,000 | |
| Common stock (110,000 x $0.01) | 1,100 | |
| Additional paid-in capital | 1,098,900 |
When is it an extinguishment instead?
Extinguishment accounting applies when the settlement does not include all consideration, in form and amount, required by the existing terms. For example, principal that the terms require in cash is partly settled in shares, or fewer shares are issued than the terms require. It also applies when the conversion option was not substantive at issuance. In that case the fair value of the equity issued is part of the debt's reacquisition price. A transaction designed to induce conversion that fails the induced conversion criteria and is not a modification is an extinguishment as well. If the instrument was exchanged or modified without being deemed substantially different within the year before the offer acceptance date, ASU 2024-04 compares the offer with the terms that existed one year before acceptance. The debt-side mechanics of gain or loss are the same as in /us/blog/asc-470-debt-modification-vs-extinguishment-10-percent-test.
Audit angle
What the auditor tests:
- The terms. Read the note, amendments and side letters. List the conversion, redemption, put and change-of-control features, and the settlement method on conversion: all shares, cash and shares, or all cash.
- The issuance model. Obtain management's analysis of derivative separation and of any premium. Challenge it against the contract. See /us/standards/asc-480-distinguishing-liabilities-from-equity when a feature points toward liability classification.
- Settlement classification. For every conversion in the year, compare the consideration delivered with what the original terms required, in form and amount. Conclusions of induced conversion or extinguishment need a written trail, including the evidence that the option was substantive at issuance.
- The entry. Agree shares issued to the transfer agent or cap table, agree par and APIC, and confirm unamortized costs were cleared. Recompute any induced conversion expense at the fair value on the acceptance date.
- Interest through the conversion date. Agree interest accrued to the conversion date and how it was settled, in cash or in shares.
- Adoption. Confirm the ASU 2020-06 effective date applied to the entity and that any ASU 2024-04 early adoption was made only after adopting ASU 2020-06.
Common misstatements: a gain or loss booked on a conversion under original terms, shares valued at market in a plain conversion, an induced conversion expense missed because the offer looked like routine negotiation, unamortized issuance costs left on the books after the note converts, and extinguishment accounting applied to a settlement that met all the induced conversion criteria.
Questions auditors ask
Does the stock price at conversion matter?
For a conversion under the original terms of an unbifurcated note, no. The carrying amount moves to equity. The stock price matters in an induced conversion, where the excess consideration is measured at fair value, and in an extinguishment, where equity issued is part of the reacquisition price.
Does an out-of-the-money conversion option rule out induced conversion treatment?
No. It can still qualify if it was substantive at issuance and at acceptance, and the instrument does not have to be convertible at the time of the offer.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Financing transactions guide, 6.8 Conversion accounting (conversion under original terms, 30 to 60 day limited period): https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financing_transactio/financing_transactio_US/ch_6_convertible_debt/68_conversion_accounting.html
- FASB, ASU 2020-06, Accounting for Convertible Instruments and Contracts in an Entity's Own Equity (effective dates, models, transition): https://storage.fasb.org/ASU%202020-06.pdf
- FASB, ASU 2024-04, Induced Conversions of Convertible Debt Instruments (text of ASC 470-20-40-4 and 40-13 to 40-16, criteria, effective date, early adoption, one-year lookback, 30 and 60 day examples): https://storage.fasb.org/ASU%202024-04.pdf
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