Convertible Debt Under ASU 2020-06: Simplified Accounting for the CPA Exam

Convertible Debt Accounting Under ASU 2020-06

ASU 2020-06 (Accounting for Convertible Instruments and Contracts in an Entity's Own Equity) simplified the accounting for convertible instruments by eliminating the beneficial conversion feature (BCF) model and the cash conversion feature model from ASC 470-20. Under the updated guidance, most convertible debt instruments are accounted for as a single liability measured at amortized cost, without separating an equity component. This standard is effective for public business entities for fiscal years beginning after December 15, 2021, and is now the primary framework tested on the CPA FAR exam.

What Changed with ASU 2020-06

Before ASU 2020-06, convertible debt with certain features required bifurcation of the debt and equity components. The cash conversion model required separation when the instrument could be settled partly in cash and partly in shares. The beneficial conversion feature model required recognition of additional paid-in capital when the conversion price was below the market price of the stock at issuance. Both models resulted in higher interest expense and a discount on the debt that was amortized over the instrument's life.

ASU 2020-06 eliminated both models, retaining only the requirement to separate an embedded conversion feature that must be accounted for as a derivative under ASC 815 (when the conversion feature is not clearly and closely related to the host and does not qualify for the scope exception for contracts in the entity's own equity). As a result, most convertible debt is now recorded entirely as a liability at its face amount, with no equity component.

Initial Recognition: Single Liability Model

Under the single liability model, when an entity issues convertible debt, it records the entire proceeds as a liability. There is no allocation of proceeds between debt and equity. The journal entry debits cash for the proceeds received and credits notes payable (or bonds payable) for the face amount. If the debt is issued at a premium or discount, the difference between proceeds and face value is recorded as a premium or discount on the debt and amortized using the effective interest method.

Issuance costs are allocated entirely to the liability and recognized as a reduction of the carrying amount of the debt (or as a deferred charge), amortized over the term of the instrument.

Subsequent Measurement

The convertible debt is measured at amortized cost. Interest expense is recognized using the effective interest method based on the coupon rate (if issued at par) or the effective rate (if issued at a premium or discount). There is no additional non-cash interest expense from amortization of a discount related to a separated equity component, as existed under the prior models. This generally results in lower reported interest expense compared to the prior guidance.

Conversion Accounting

When the holder converts the debt, the entity derecognizes the carrying amount of the debt (including any unamortized premium or discount) and recognizes common stock and additional paid-in capital. No gain or loss is recognized upon conversion when the instrument is converted according to its original terms. If the conversion is induced (the entity offers additional consideration to encourage conversion), the fair value of the additional consideration is recognized as an expense.

Earnings Per Share Implications

ASU 2020-06 also changed the diluted EPS calculation for convertible instruments. The treasury stock method is no longer permitted for convertible instruments; instead, the if-converted method is required for all convertible instruments. Under the if-converted method, diluted EPS assumes that the convertible debt was converted at the beginning of the period (or at issuance if later). The numerator is adjusted by adding back the interest expense (net of tax) on the convertible debt, and the denominator is increased by the number of shares that would be issued upon conversion.

The if-converted method is applied only if it is dilutive. If the effect of assumed conversion would increase EPS (an antidilutive effect), the convertible instrument is excluded from the diluted EPS calculation.

Remaining Separation Requirements

While ASU 2020-06 eliminated the BCF and cash conversion models, embedded conversion features that meet the definition of a derivative under ASC 815 and do not qualify for the scope exception for contracts in an entity's own equity must still be separated and accounted for at fair value. This situation is less common and typically arises when the conversion feature has exotic terms that do not meet the equity classification criteria under ASC 815-40.

Exam Preparation Tips

• Know that most convertible debt is now recorded as a single liability at amortized cost -- no equity component separation.
• Understand what was eliminated: the BCF model and the cash conversion model.
• Practice the conversion journal entry: debit notes payable (and any unamortized discount), credit common stock and APIC.
• Remember the EPS change: the if-converted method is now required; the treasury stock method is eliminated for convertible instruments.
• Know the remaining exception: embedded derivatives that do not qualify for the equity scope exception must still be separated.