Why Is Accounting for Convertible Debt So Hard?

Convertible notes can be an attractive financing option for organizations and investors. However, the extent of relevant accounting standards to consider and the significant judgments involved make accounting for convertible debts complex. Luckily, the FASB’s new accounting standard, ASU 2020-06, has simplified some aspects of this process. 

What is a convertible note? 

A convertible note is a debt that can be settled in exchange for the issuance of an organization’s shares of stock. Organizations (particularly startups, early-stage technology, and life-sciences organizations) will issue convertible notes rather than raising money through issuing stock because it’s usually easier.   

There are more legal documents to issue stock, and early-stage stock investors are generally looking for preferential terms and rights that take time and cost to negotiate. Additionally, issuing stock impacts current investors (i.e., founders and venture capital funds), which brings consideration of enterprise value and dilution in determining the stock’s selling price.  

As such, a great way to bridge the gap is to issue convertible notes (often called “bridge loans”) to investors so the details of issuing stock can be ironed out later. To incentivize investors to accept these notes, terms that provide sweeteners often show up in the agreements, including but not limited to: 

• A guaranteed conversion price set equal to or below the fair market value of the company’s stock on the date the note is issued; 
• The ability to settle the convertible note in exchange for stock issued in a future round of equity financing (i.e., Series A Preferred Stock) or IPO at a discounted price ranging from 10% to 30% of the price of stock sold to investors in that round; and 
• The ability to convert the note into the company’s stock at a stated valuation cap. 

Why are convertible notes so hard to account for? 

Unfortunately, convertible notes bring with them a slew of accounting considerations. Foremost among them is whether those “sweeteners” constitute “embedded features.” Embedded features include conversion rights, redemption rights (sometimes considered put or call features), and beneficial rights written in agreements. These embedded features may require a portion of the proceeds to be allocated and presented separately on the organization’s balance sheet. 

Organizations also need to consider multiple accounting standards, including: 

ASC 815: Derivatives and Hedging. If an embedded feature meets the definition of a derivative, the feature must be bifurcated and valued at fair value upon issuance and at each subsequent reporting period.  

ASC 405-50: Debt Extinguishments and Modifications. Changing the terms of convertible notes requires additional consideration if a change in a conversion feature is substantial and relevant to the 10% cash flow test. Additionally, the ultimate settlement of debt into shares may constitute a debt extinguishment. 

ASC 825: Fair Value Option. You’ve most likely accounted for debt issued at the value of proceeds received, less issuance costs. However, a “hybrid instrument” (convertible notes with embedded features) may be measured at fair value with changes reported in earnings. There are exceptions, such as notes requiring bifurcation of a cash conversion or beneficial conversion feature. 

Common “bifurcations” include:

•  A liability attributable to a warrant issued in tandem with the notes; 
• A derivative liability representing the substantial discount; and 
• A beneficial conversion feature recorded to equity. 

The bifurcated values are recognized with an offsetting entry to debt issuance costs, which is amortized through interest expense until the original note returns to its original value. Any liabilities recorded at fair value should be revalued at each measurement period. 

How did ASU 2020-06 simplify accounting for convertible notes? 

In August 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible notes.  

ASU 2020-06 no longer requires the separation of an embedded conversion feature to equity, which is done when allocating the interest cost paid concerning a cash conversion feature and when recording the intrinsic value of a beneficial conversion feature. The new FASB accounting standard removes the need to assess for such features. It also provides the ability to elect the fair value option for notes that would have been previously precluded from doing so due to the existence of these features, allowing a more streamlined analysis of convertible notes. 

For public business entities that meet the definition of an SEC filer (excluding entities eligible to be smaller reporting companies as defined by the SEC), the standard takes effect for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the standard will take effect for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted beginning January 1, 2021. 

What should you do when you have a convertible note? 

Step 1: Fully understand the economics and mechanics of the notes. Were any other instruments issued (i.e., warrants to purchase stock) that must be accounted for as a separate freestanding instrument? What are the different ways to settle the note, and how does each scenario play out?  

Step 2: Assess the accounting. Evaluate if there are different embedded features and whether they are conversion or redemption features. Can you adopt ASU 2020-06? Is it beneficial to elect the fair value method? 

Step 3: Find a valuation specialist. You will need to consider the short-term and long-term strategies for these instruments. When are you likely to issue new shares? What is the most probable scenario to occur, and which is the most beneficial to the investor? Then, you and the valuation specialist will determine the best way to model the various scenarios.  

Step 4: Reassess every reporting period. Until the convertible note is settled, circumstances will continue to change, and it is essential to reassess your assumptions with each major change and each reporting period for impact to the value of the instruments.