Overview

When an issuer structures a debt instrument that is mandatorily convertible into equity issued in the next round of financing at a discounted conversion price, such feature is generally not clearly and closely related to the host contract (i.e., the debt instrument).

U.S. GAAP provides the following two potential accounting approaches for such convertible debt:

1. Apply ASC 470 for the host debt and ASC 815 for the embedded derivative: The embedded feature is bifurcated and accounted for separately as a derivative at fair value through earnings, while the remaining host debt is carried at amortized cost using the effective-interest method.
2. Elect the Fair Value Option (FVO) under ASC 825-10: The issuer measures the entire hybrid debt instrument at fair value each reporting period. Subsequent changes in fair value are recognized in earnings except for changes attributable to the issuer’s own credit risk, which are presented in other comprehensive income (OCI).

Both models are conceptually consistent with U.S. GAAP but differ in how they treat measurement, income statement volatility, modification accounting, and classification in addition to differences in the fair value methodology for each model.

Income Statement Impact

ASC 470 & ASC 815: Only the fair-value changes of the embedded derivative flow through earnings. The host debt accrues interest expense using the effective interest rate, leading to steadier periodic expense recognition.

ASC 825: All changes in the fair value of the hybrid liability, including, at the issuer’s option, changes resulting from accrued interest, are recorded in earnings as a single line item except for those attributable to the issuer’s own credit risk (recognized in OCI). This results in greater potential volatility in net income.

Balance Sheet Presentation

ASC 470 & ASC 815: The derivative and host liability are presented separately, one at fair value and the other at amortized cost, resulting in a mixed measurement basis.

ASC 825: A single liability measured at fair value is presented on the balance sheet.

Current vs. Noncurrent Classification

Both ASC 470 and ASC 825 defer to ASC 210-10-45 and the ASC Master Glossary for classification. A liability is current when its settlement is expected to require the use of current assets or the creation of other current liabilities within one year. If settlement is expected beyond one year or will not require the use of current assets, the liability is noncurrent.

Under the Fair Value Option, classification follows the same maturity-based criteria as under ASC 470 even though the debt is measured at fair value. For both models, classification depends on contractual maturity and settlement terms, not the measurement basis.

If the debt can only be settled in the issuer’s own equity instruments, it does not meet the definition of a current liability under the ASC Master Glossary because settlement will not require use of current assets. Such debt remains noncurrent even if conversion could occur within one year.

Modification Accounting

ASC 470 & ASC 815: When debt is modified, the issuer must follow ASC 470-50 and ASC 470-60 guidance: (1) assess whether the change constitutes a TDR; (2) if not, evaluate modification versus extinguishment; and (3) derecognize and recognize new debt if extinguished.

ASC 825: When debt measured under the FVO is modified, the issuer evaluates whether the modified instrument still qualifies for the FVO. If eligible, the modification’s impact is reflected in the change in fair value.

Credit-Risk Presentation

Under ASC 825, changes in the issuer’s own credit risk are recognized in OCI, while other fair-value changes are recorded in earnings. Under ASC 470 & ASC 815, changes in the issuer’s credit risk are reflected in the derivative’s valuation but not separately identified in OCI.

Valuation Considerations

Valuing convertible debt with a discounted conversion feature requires a robust fair-value framework that appropriately captures both the debt’s credit characteristics and the economic impact of the embedded conversion option in accordance with ASC 820 using observable and unobservable market-based inputs consistent with Level 2 and Level 3 fair value measurements.

ASC 470 & ASC 815 (Bifurcation Approach)

When the conversion feature is bifurcated and accounted for separately as a derivative, its fair value is often determined using a “with-and-without” approach. Under this method, the fair value of the entire convertible note (with the embedded feature) and the debt host alone (without the feature) are both estimated using consistent market-based assumptions. The difference between the two valuations represents the fair value of the embedded derivative.

Common techniques include lattice or binomial models, Monte-Carlo simulations, and recently, more streamlined scenario-based methods, such as Bond Plus Call or As-Converted Plus Risky Put. These approaches model multiple conversion, redemption, or liquidity scenarios, incorporating assumptions about conversion discounts, valuation caps, mandatory or optional conversion events, and changes in market yields or credit spreads. Subsequent valuations are calibrated to the implied yield determined at inception and updated each reporting period to reflect changes in market conditions, issuer credit, or exit probabilities.

ASC 825 (Fair Value Option)

Under the FVO, the entire hybrid convertible instrument, including the embedded conversion feature, is measured at fair value as a single unit of account. The valuation does not require separation of the host and derivative components, eliminating the need for the “with-and-without” approach. Instead, the model focuses on estimating the overall fair value of the convertible instrument, incorporating both debt and optionality in one measure.

Inputs are generally like those used in the bifurcation model (e.g., discount rates, volatility, credit spreads, and conversion probabilities), but the FVO typically results in a streamlined valuation process since only the aggregate instrument is measured and updated each period.

Disclosure and Presentation

ASC 470 & ASC 815 require standard debt and derivative disclosures under their respective codifications. FVO consolidates disclosures under one measurement basis, while bifurcation produces separate disclosures for the host and derivative.

ASC 825 requires ASC 820 fair-value disclosures, including the fair value hierarchy level, valuation methodology, sensitivity, and OCI reconciliation.

Conclusion

ASC 470 & ASC 815 maintain traditional amortized cost accounting using the effective interest rate method for the host debt instrument, yielding predictable interest recognition throughout the debt’s term and a more familiar presentation, but they require a fair value-based recurring measurement model for the embedded derivative and a more complex modification assessment.

In contrast, the Fair Value Option (ASC 825) provides a fair value-based measurement model for the debt instrument that reflects changes in fair value in earnings (other than own-credit in OCI). It simplifies modification accounting and offers a single fair-value presentation although it introduces greater earnings volatility.

While both approaches require fair value measurement, the FVO requires only a single valuation of the entire instrument, whereas the bifurcation approach requires finding agreement on the various derivatives to be bifurcated as well as two separate valuation frameworks under the with-and-without method.