How Convertible Debt and Embedded Derivatives Are Accounted for under IFRS 9/IAS 32 and ASC 470-20/815

Convertible debt raises capital with a debt host and an option to convert into the issuer’s own shares. Accounting focuses on classification (liability vs equity), measurement (amortized cost vs fair value), and whether embedded features must be separated. Under IFRS (IAS 32, IFRS 9), many convertibles are compound instruments split into liability and equity components if the conversion option meets the fixed-for-fixed criterion. Under US GAAP (ASC 470-20 as amended by ASU 2020-06, ASC 815-15/40), most traditional cash-settled or plain convertibles are accounted for as a single liability at amortized cost unless an embedded derivative fails the equity-scope exception and must be bifurcated at fair value through earnings.

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How convertible features and embedded options arise.

Convertible notes typically embed one or more features: a conversion option, change-of-control puts, issuer calls, coupon step-ups, or make-wholes. Some notes permit cash-or-share settlement at the issuer’s option; others require net share settlement.These features drive two critical assessments:

1. Instrument classification and split (IFRS compound accounting vs GAAP single liability in many cases);

2. Derivative scope (whether a feature must be separated and measured at fair value).

If a feature changes timing or amount of cash flows in a way not closely related to a basic debt host (or fails equity-classification tests), it is typically an embedded derivative accounted for at FVTPL (IFRS 9/ASC 815).

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Measurement under IFRS: liability–equity split and derivative bifurcation.

1) Compound instrument (fixed-for-fixed conversion).If the conversion option entitles the holder to a fixed number of the issuer’s own shares for a fixed amount of cash (or fixed liability carrying amount), the option is equity under IAS 32. At initial recognition:

• Measure the liability at the present value of contractual cash flows discounted at the market rate for similar non-convertible debt.

• Assign the residual to equity (conversion option).

• Subsequent measurement: liability at amortized cost using the effective interest rate (EIR); equity is not remeasured.

Journal entry (IFRS — par issue 10,000,000; market yield for non-convertible 7%; coupon 3%; 5-year term):

• Debit: Cash 10,000,000

• Credit: Liability – Convertible Note (PV at 7%) 9,100,000

• Credit: Equity – Conversion Option 900,000

Periodic accounting:

• Debit: Finance Cost (using EIR @ 7%) xxx

• Credit: Liability – Convertible Note xxx

On conversion (no gain/loss):

• Debit: Liability – Convertible Note (carrying amount) xxx

• Debit: Equity – Conversion Option xxx

• Credit: Share Capital / Share Premium xxx

2) Embedded derivative (fails fixed-for-fixed or contains non-closely-related terms).If the conversion ratio floats with non-own-equity variables (e.g., commodity index, FX), or settlement alternatives cause failure of equity classification, the option is an embedded derivative liability under IFRS 9:

• Separate the derivative at fair value (FVTPL) at inception; host debt at amortized cost.

• Revalue the derivative through profit or loss each period.

Journal entry (IFRS — bifurcated):

• Debit: Cash 10,000,000

• Credit: Host Debt (amortized cost) 9,600,000

• Credit: Embedded Derivative Liability (FVTPL) 400,000

Period-end (derivative FV ↑ 60,000):

• Debit: Loss on Embedded Derivative 60,000

• Credit: Embedded Derivative Liability 60,000

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Measurement under US GAAP after ASU 2020-06.

1) Single-unit accounting is the default.ASU 2020-06 eliminated most beneficial conversion feature (BCF) and cash conversion separations. Many convertibles are now one liability at amortized cost with no equity component at inception. Effective interest reflects fees and discounts.

Journal entry (GAAP — par issue 10,000,000; issuance costs 200,000; coupon 3%; 5-year term):

• Debit: Cash 9,800,000

• Debit: Debt Issuance Costs (contra-liability) 200,000

• Credit: Convertible Debt (ASC 470) 10,000,000

Amortize issuance costs through interest expense (ASC 835-30) using EIR.

2) Embedded derivatives remain possible (ASC 815).If the conversion option fails the equity-scope exception under ASC 815-40 (e.g., not indexed to the issuer’s own stock, or the issuer lacks sufficient authorized and unissued shares without cash settlement, or settlement alternatives create net cash outcomes), then bifurcate and fair-value the embedded derivative.

• Host debt stays at amortized cost; the separated embedded derivative runs through earnings each period.

Journal entry (GAAP — bifurcated):

• Debit: Cash 10,000,000

• Credit: Convertible Debt (ASC 470) 9,850,000

• Credit: Embedded Derivative Liability (ASC 815) 150,000

Period-end FV loss 45,000:

• Debit: Loss on Derivative 45,000

• Credit: Embedded Derivative Liability 45,000

3) EPS effects.ASU 2020-06 changes diluted EPS by simplifying if-converted and treasury-stock methods. Entities reassess dilution consistently across periods and instruments.

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Key classification tests and decision path.

IFRS (IAS 32/IFRS 9).

• Fixed-for-fixed? If yes, treat conversion option as equity and split instrument.

• If no, and feature alters cash flows in a non-closely-related way → bifurcate as embedded derivative (FVTPL).

• Host debt measured at amortized cost unless designated at FVTPL.

• Own-equity settlement alternatives must still pass equity-classification; issuer-choice cash settlement often fails equity and drives derivative accounting.

US GAAP (ASC 470-20/815-15/815-40).

• Start with single liability.

• Test equity-scope exception under ASC 815-40 (indexed-to-own-stock; ability to settle in shares; no cash top-ups).

• If exception fails → bifurcate embedded derivative at fair value.

• If exception passes → stay single liability at amortized cost (no equity split, no BCF).

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Comparative table: IFRS vs US GAAP.

Aspect	IFRS (IAS 32 / IFRS 9)	US GAAP (ASC 470-20 / 815)
Default model	Compound: split into liability (amortized cost) and equity if fixed-for-fixed.	Single liability post-ASU 2020-06; no BCF/cash-conversion separation in most cases.
Conversion option	Equity if fixed-for-fixed; otherwise embedded derivative (FVTPL).	Equity-scope exception under ASC 815-40; if it fails, bifurcate at fair value.
Subsequent measurement	Liability at amortized cost; equity not remeasured; derivatives at FVTPL.	Debt at amortized cost; any bifurcated derivative at FV through earnings.
EPS	If-converted with compound instruments; potential dilution from equity component.	Simplified diluted EPS (ASU 2020-06) using if-converted/treasury stock consistently.
Early settlement/modification	Apply IFRS 9 modification/extinguishment (10% test); re-measure derivative/equity as required.	Apply ASC 470 modification/extinguishment model; reassess derivative bifurcation.

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Presentation and disclosures.

Balance sheet (IFRS): show liability within borrowings and a separate equity component within equity for compound instruments; embedded derivatives presented within derivative liabilities.Balance sheet (GAAP): show convertible debt as non-current (unless due within 12 months); any embedded derivative presented separately.

IFRS 7 disclosures: terms, EIR, maturity profile, fair-value hierarchy for derivatives, and reconciliation of the liability’s carrying amount; description of fixed-for-fixed assessment.US GAAP disclosures: debt terms, issuance costs, fair value of the debt and derivative (if any), EPS effects, and any settlement alternatives.

Example presentation (IFRS):

Equity and Liabilities	Amount (USD)
Equity:
Share Capital and Premium	18,400,000
Equity – Conversion Option	900,000
Non-Current Liabilities:
Borrowings – Convertible Note	9,320,000
Derivative Liabilities (if any)	160,000

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Journal entries for common scenarios.

1) Induced conversion (IFRS/GAAP).If the issuer offers a sweetener (e.g., extra shares) to accelerate conversion:

• Recognize the incremental fair value of the sweetener as expense (IFRS: usually P&L; GAAP: debt conversion inducement expense).

• Derecognize the liability (and IFRS equity component) and issue shares.

2) Cash-settled partial repurchase of a compound instrument (IFRS).Allocate the consideration between the liability and equity components based on relative fair values; recognize gain/loss only on the liability portion; equity changes go directly to equity.

3) Modification of terms (both frameworks).Apply modification guidance (IFRS 9 10% test; ASC 470 modification vs extinguishment). If extinguished, derecognize the old liability (and derivative), recognize the new one at fair value, and record any gain/loss.

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Impact on financial performance and ratios.

Under IFRS compound accounting, EIR is higher (liability recognized below proceeds), increasing finance costs and reducing interest coverage early in the life of the note. Under GAAP’s single-unit model, interest expense is typically lower than IFRS for otherwise identical terms.If an embedded derivative exists (both frameworks), earnings volatility increases due to fair-value changes. Balance-sheet leverage is affected by whether an equity component is recognized (IFRS) or not (GAAP).

Analysts normalize:

• IFRS: add back non-cash derivative losses and reconcile EIR-driven interest.

• GAAP: isolate derivative P&L and inducement/modification charges; scrutinize settlement alternatives that could force cash.

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Worked mini-example comparing IFRS and US GAAP.

Terms: 5-year 3% coupon, par 10,000,000; market yield for straight debt 7%; fixed-for-fixed conversion at 1,000,000 shares.

IFRS (compound):

• Liability (PV @ 7%) ≈ 9,100,000; Equity ≈ 900,000.

• EIR ≈ 7% → higher annual interest vs coupon.

• On conversion: reclassify liability + equity to share capital/premium.

US GAAP (single liability):

• No equity split. Initial carrying amount ≈ 10,000,000 less issuance costs.

• Interest expense nearer coupon plus amortization of costs.

• On conversion: derecognize liability; issue shares; recognize any inducement cost if applicable.

Result: IFRS shows higher ongoing interest expense and equity at inception; GAAP shows a larger liability and lower finance costs absent derivatives.

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Operational considerations.

Treasury and accounting should finalize settlement mechanics (cash vs shares, net share settlement), confirm authorized shares to avoid cash-settlement contingencies, and document conversion ratios, resets, make-wholes, and anti-dilution terms. Systems must track EIR, modifications, EPS impacts, and any derivative fair values. Audit-ready memos should evidence fixed-for-fixed analysis (IFRS) and ASC 815-40 scope exception testing (GAAP), with sensitivity analysis for potential trigger events.

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