How Convertible Debt Is Split Between Liability and Equity on the Balance Sheet

Convertible debt, also known as convertible bonds or notes, is a hybrid financial instrument that combines features of both debt and equity. It allows the holder to convert the debt into a fixed number of shares of the issuing company, usually at the holder’s option. On the balance sheet, convertible debt is separated into its liability component, representing the obligation to pay interest and principal, and its equity component, representing the value of the conversion option. This split ensures that the financial statements reflect both the borrowing cost and the potential dilution embedded in the instrument.

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How convertible debt arises

Companies issue convertible debt as a financing tool that offers lower interest costs in exchange for granting investors an option to convert the debt into equity. It is often used by firms in growth stages or industries where future share appreciation is expected.

For example, a company issues 1,000,000 of five-year convertible bonds with a 3 percent coupon, convertible into 50,000 shares. If similar non-convertible debt carries a 6 percent interest rate, the conversion feature adds extra value for the investor. The difference between the proceeds and the fair value of the liability is recorded as equity.

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Presentation on the balance sheet

Convertible debt is presented as follows:

• Liability component: Recorded at the present value of future cash flows (interest and principal) discounted at the market rate for similar non-convertible debt.

• Equity component: Recorded as “Equity – Conversion Option” or “Additional Paid-in Capital (APIC) – Conversion Feature.”

Example:

Component	Amount (USD)
Convertible Bonds (Liability)	920,000
Equity Component (Conversion Option)	80,000
Total Proceeds	1,000,000

On the balance sheet, the liability portion appears under non-current liabilities, while the equity portion forms part of shareholders’ equity.

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Journal entries for convertible debt

At issuance:

• Debit: Cash 1,000,000

• Credit: Bonds Payable 920,000

• Credit: APIC – Conversion Option 80,000

To record interest expense using the effective interest method:

• Debit: Interest Expense 55,200

• Credit: Cash (Coupon Payment) 30,000

• Credit: Bonds Payable (Amortization of Discount) 25,200

Upon conversion of the bonds into shares:

• Debit: Bonds Payable 1,000,000

• Debit: APIC – Conversion Option 80,000

• Credit: Common Stock (Par Value) 50,000

• Credit: APIC – Common Stock 1,030,000

This accounting recognizes the extinguishment of the debt and the issuance of shares without any gain or loss.

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Standards under IFRS and US GAAP

• IFRS (IAS 32 and IFRS 9): Requires separation of convertible debt into liability and equity components at initial recognition. The liability is measured first, and the residual amount is assigned to equity. No remeasurement of the equity component is allowed after initial recognition.

• US GAAP (ASC 470-20 – Debt with Conversion and Other Options): Historically required separation under the “cash conversion” model, but since 2020 simplifications, many convertible instruments are now accounted for entirely as liabilities unless they contain substantial conversion features.

Under both frameworks, the liability is measured at amortized cost, and interest expense is recognized using the effective interest method.

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Impact on financial performance and ratios

The separation of convertible debt affects both leverage and profitability ratios. The liability component increases reported debt and interest expense, while the equity component reduces leverage ratios such as debt-to-equity.

For example, a company with total equity of 5,000,000 and convertible debt (920,000 liability, 80,000 equity) will show a debt-to-equity ratio of 0.18 instead of 0.20 if the full 1,000,000 were treated as debt.

However, if conversion occurs, equity increases and interest obligations disappear, improving coverage ratios but diluting existing shareholders. Analysts often model “if-converted” scenarios to understand the potential impact on earnings per share.

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Disclosures required for convertible debt

Financial statements must disclose:

• Terms of conversion, including price, ratio, and maturity.

• Fair value of liability and equity components.

• Interest expense recognized using the effective interest method.

• Number of shares issuable upon conversion.

IFRS additionally requires disclosure of any reclassification or extinguishment effects if conversions or redemptions occur before maturity.

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Operational considerations

Convertible debt can be an attractive financing mechanism for companies seeking capital while minimizing immediate dilution. However, it introduces complexity in accounting, interest recognition, and potential changes to capital structure upon conversion.

From a strategic perspective, management must balance lower financing costs against future dilution risk and investor expectations. For stakeholders, the split between debt and equity provides insight into how much of the instrument represents genuine borrowing versus potential ownership transition.

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