Convertible notes are the standard bridge financing for early-stage companies, and they show up in a first-year audit with little documentation and a large balance. ASC 470-20, Debt with Conversion and Other Options, governs how the issuer accounts for them. ASU 2020-06 changed the topic by cutting the number of models, which means most convertible notes now sit on the balance sheet as a single liability with no separate equity component. This page explains the models, the effective dates by entity type, and ASU 2024-04 on induced conversions. For debt classification and covenants, see ASC 470 debt classification.
What is a convertible instrument?
A convertible instrument is a debt or equity instrument with an embedded feature that requires or allows the holder to convert it into equity shares of the issuer. A bond that the holder can convert into a fixed number of common shares at any time through maturity is the usual example. Some instruments with features called conversion options are not convertible instruments for this purpose, such as an embedded conversion option that can be separately exercised, or an instrument convertible into a variable number of shares with an aggregate fair value based predominantly on a fixed monetary amount. Those fall under other guidance, including ASC 480 and ASC 815.
What did ASU 2020-06 change?
ASU 2020-06 requires convertible debt to be accounted for under one of three models:
| Model | Treatment |
|---|---|
| Embedded derivative | Proceeds are allocated to the embedded conversion feature at fair value, with the rest allocated to the host contract. The feature is remeasured at fair value through earnings. |
| Substantial premium | Proceeds are allocated to equity for the premium. |
| No proceeds allocated | All proceeds are allocated to the entire instrument, classified as a liability. There is no separate accounting for the conversion feature initially or subsequently. |
The ASU eliminated the cash conversion and beneficial conversion feature (BCF) models. Before the ASU, a note convertible at a price below the share's fair value on the commitment date produced a BCF recorded in equity, with the debt discount amortized to interest expense. Under the ASU, more convertible instruments are accounted for as a single unit.
The ASU also changed ASC 815-40, the guidance on contracts in an entity's own equity, by removing some conditions for equity classification. Questions about warrants and conversion features issued with a note should be asked together.
On the premium model, US GAAP does not define a substantial premium. KPMG notes that historically a premium of 10 percent or more above the principal amount has generally been viewed as substantial in practice, and says future judgments may be informed by FASB's reasons for retaining the model, namely avoiding net interest income when premium amortization exceeds cash interest.
What are the effective dates?
ASU 2020-06 is effective for fiscal years beginning after December 15, 2021 for public business entities that are SEC filers and not eligible to be smaller reporting companies, and for fiscal years beginning after December 15, 2023 for all other entities, including private companies and smaller reporting companies. Early adoption was permitted. Entities used either a modified retrospective or a fully retrospective approach. A calendar-year private company therefore applies the ASU for 2024, and any private company still on the old models should treat that as a prior-period matter in the file.
For induced conversions, ASU 2024-04 amends the guidance on whether induced conversion accounting or extinguishment accounting applies to certain settlements of convertible debt that do not follow the instrument's preexisting terms. It is effective for all entities for annual and interim periods in fiscal years beginning after December 15, 2025. Early adoption is permitted for entities that have adopted ASU 2020-06. That makes 2026 the first year for a calendar-year private company.
Worked illustration
Illustrative numbers. A private company issues a $1,000,000 convertible note at par, with 8 percent interest and a conversion price at a discount to the next preferred round, and pays $40,000 of issuance costs. It concludes the conversion feature is not required to be bifurcated and the note was not issued at a substantial premium, so the no-proceeds-allocated model applies.
- Initial carrying amount: $1,000,000 - $40,000 = $960,000, a liability.
- Cash interest each year: $1,000,000 x 8% = $80,000.
- Issuance costs are amortized to interest expense with the effective interest method. Over a five-year term, a rough straight-line proxy is $40,000 / 5 = $8,000 a year, so total annual interest expense is about $88,000. The effective interest method gives slightly different figures year to year.
- No amount is recorded in equity for the conversion feature, and no BCF discount is amortized.
Substantial premium variation. If the company received $1,100,000 for a note with $1,000,000 of principal and a conversion feature that qualifies under the premium model, the $100,000 premium is recorded in equity and the liability is $1,000,000, with the premium not amortized.
What do auditors do with convertible notes?
- Read the note, the side letters, and any amendments, and list every conversion, redemption, put and change-of-control feature.
- Obtain management's memo on whether any feature is a derivative requiring bifurcation under ASC 815, and challenge it with the contract terms.
- Check whether the instrument was issued at a premium and how the premium was evaluated.
- Recompute interest and issuance cost amortization. See the debt and interest rollforward schedule.
- Confirm balances and terms with the holders. See audit confirmations.
- Evaluate subsequent events such as a conversion in the next equity round. See subsequent events.
- Check classification (current if due within the period) and disclosures, including conversion terms and maturities.
Common problems
Practice observations, not requirements:
- Notes with a discount-to-next-round conversion, which can settle at a variable number of shares, are treated as plain debt when a separate analysis under ASC 480 or ASC 815 is needed.
- Warrants issued with the note are not allocated any proceeds or are recorded without a classification analysis.
- Prior-year BCF balances are carried forward after the adoption date, as though the old model still applied.
- Accrued interest is capitalized into principal without evaluating a modification.
- Conversions are recorded without the extinguishment or induced conversion analysis, particularly when terms were changed to induce holders to convert.
FAQ
Do SAFEs fall under ASC 470-20?
Not as convertible debt. A SAFE is not debt and is generally analyzed under ASC 480 and ASC 815-40, depending on its terms.
Did ASU 2020-06 change earnings per share?
Yes. The ASU requires the if-converted method for diluted EPS for convertible instruments. EPS applies to entities that present it, which generally means public entities.
Is a private company required to adopt ASU 2020-06?
Yes. It was effective for private companies for fiscal years beginning after December 15, 2023.
What is an induced conversion?
A settlement where the issuer offers incentives to holders to convert, such as a lower conversion price or extra shares, and the conversion happens under changed terms. ASU 2024-04 refines when induced conversion accounting applies instead of extinguishment accounting.
Sources
- FASB Accounting Standards Codification Subtopic 470-20, Debt with Conversion and Other Options, and ASU 2020-06 and ASU 2024-04: https://www.fasb.org
- KPMG, Handbook: Debt and equity financing (2025), chapter 10 (convertible instruments), including the overview of the three models, the substantial premium discussion, and the ASU 2024-04 summary
- KPMG, Accounting standards effective dates (March 2026) for ASU 2020-06 and ASU 2024-04 effective dates by entity type
Related
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