A convertible note accounting entry starts simple: on the day the money arrives, you debit Cash and credit Convertible Note Payable for the full face amount of the note. From there, you accrue interest each period, and when the note converts you move the principal plus accrued interest off the liability side and into stock and additional paid-in capital. Under current U.S. GAAP, most convertible notes are carried as a single liability at amortized cost from issuance through conversion or maturity, so the entries stay compact and no gain or loss runs through the income statement on conversion.
The framework behind that simplicity is ASC 470-20 as rewritten by ASU 2020-06. The update eliminated the beneficial conversion feature model and the cash conversion model, both of which used to force companies to split convertible debt into separate liability and equity pieces. It took effect for large SEC filers in fiscal years beginning after December 15, 2021, and for all other entities in fiscal years beginning after December 15, 2023.1FASB. ASU 2020-06 Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity A convertible debt instrument is now accounted for as a single liability at amortized cost, provided no feature requires derivative treatment under ASC 815 and no substantial premium was recorded as paid-in capital at issuance.2PwC Viewpoint. ASU 2020-06 Debt with Conversion and Other Options The conversion feature stays embedded in the host contract. Older guidance discussing BCF entries no longer applies.
The Issuance Entry
When the investor’s wire hits, book the full face value. A $500,000 convertible note produces a $500,000 debit to Cash and a $500,000 credit to Convertible Note Payable. Nothing is stripped out for the embedded conversion feature.
Balance sheet classification depends on what could happen in the next twelve months. If the maturity date falls within one year of the balance sheet date, or the holder can demand repayment or put the note within that window, it belongs in current liabilities. The same treatment applies if the issuer could be required to settle part of the conversion value in cash, even when the conversion option is out of the money. Most early-stage notes, though, sit in non-current liabilities: they convert on a qualified financing round that hasn’t happened yet, and the holder’s conversion right settles in shares rather than cash. A share-settled conversion right does not pull the note into current liabilities.3Deloitte Accounting Research Tool. Balance Sheet Classification – 13.10 Convertible Debt
Accruing Interest Each Period
Convertible notes carry a stated rate, and interest has to be recognized as it accrues whether or not any cash moves. Most startup convertible notes don’t pay interest in cash during the note’s life; the interest just builds up until conversion or maturity.
The periodic entry is a debit to Interest Expense and a credit to Accrued Interest Payable. Interest Expense hits the income statement and reduces net income. Accrued Interest Payable stacks up on the balance sheet, eventually either converting into equity alongside the principal or getting paid in cash at maturity.
PIK Interest
Some notes include a paid-in-kind feature, where accrued interest rolls into the principal balance instead of sitting in a separate liability account. Under a PIK arrangement, the issuer is essentially issuing additional debt to settle the interest obligation.4Deloitte Accounting Research Tool. Embedded Commitments Including PIK Interest and Dividend Features The PIK entry is a debit to Interest Expense and a credit directly to Convertible Note Payable. The result is a higher principal balance that converts into more shares when the trigger event occurs.
The Conversion Entry
Conversion is the entry that transforms the balance sheet. When a qualifying event triggers conversion, the note’s entire carrying amount moves from liabilities to equity. Under ASC 470-20-40-4, a convertible note that has been accounted for entirely as a liability and converts on its original terms is derecognized at carrying amount (including any unamortized premium, discount, or issuance costs), reduced by any cash paid, and the balance is recognized in the capital accounts. No gain or loss runs through the income statement.5FASB. FASB Staff Document – ASC 470-20-40-4 Convertible Debt Conversions
The mechanics: debit Convertible Note Payable for the principal, debit Accrued Interest Payable for the accumulated interest, credit the stock account (Common or Preferred) for the par value of the shares issued, and route the remainder to Additional Paid-in Capital.
A Worked Example
A $100,000 note has accrued $5,000 in interest by the time a Series A round triggers conversion. The total converting is $105,000. The conversion price, set at whichever is more favorable to the investor between the valuation cap price and the discounted round price, works out to $1.00 per share. That produces 105,000 shares of Preferred Stock.
If the Preferred Stock carries a $0.0001 par value, the stock account receives just $10.50 (105,000 × $0.0001). The remaining $104,989.50 goes to APIC:
- Debit Convertible Note Payable $100,000
- Debit Accrued Interest Payable $5,000
- Credit Preferred Stock $10.50
- Credit APIC $104,989.50
The par value allocation is almost always a rounding error, because most venture-backed companies set par value at a fraction of a cent. Nearly the entire conversion value lands in APIC.
How the Share Count Gets Set
The conversion price is not itself an accounting standard, but it drives share count and therefore the par-value and APIC split. Convertible notes typically convert at the lower of two calculated prices. The cap price equals the valuation cap divided by the company’s fully diluted share count. The discount price equals the price per share in the new financing round multiplied by one minus the discount rate. Whichever produces the lower per-share price is what the investor pays, and the total converting balance divided by that price gives the number of shares to issue.
Cash Repayment at Maturity
If no qualifying financing round occurs before maturity, the company generally must repay principal and all accrued interest in cash. The entry mirrors the issuance and accrual entries: debit Convertible Note Payable for the principal, debit Accrued Interest Payable for the accumulated interest, and credit Cash for the total disbursed.
No gain or loss hits the income statement on repayment, because interest expense was recognized during the accrual periods. A gain or loss on extinguishment would arise only if the note’s carrying value differs from the repayment amount. For a standard note carried at face with interest accrued separately, the numbers match and the entry is clean.
When the Terms Change Before Conversion
Convertible notes get renegotiated more often than founders expect. When the terms of an existing note change, the question is whether you have a new instrument or just a tweaked old one. ASC 470-50 draws the line using three tests. If any one is triggered, the old note is treated as extinguished and a new note is recognized:6Deloitte Accounting Research Tool. Determining Whether Debt Terms Are Substantially Different
- The 10 percent cash flow test. The present value of future cash flows under the new terms differs by at least 10 percent from the present value under the old terms.
- The conversion option value change. The fair value of the embedded conversion option changes by at least 10 percent of the original debt’s carrying amount.
- Addition or removal of a substantive conversion option.
Extinguishment accounting means derecognizing the old note and booking the new one at fair value, with any difference flowing through the income statement as a gain or loss. If none of the three tests is triggered, the change is a modification, and you adjust the effective interest rate prospectively without touching the income statement.
Induced Conversions
A related situation arises when the company sweetens conversion terms to encourage the holder to convert before a natural trigger event. When the issuer offers additional consideration beyond what the original terms provide, the excess value is recognized as inducement expense. The expense equals the difference between the value of what was actually issued and the value of what was issuable under the original conversion terms.7Deloitte Accounting Research Tool. FASB Issues Final Standard on Induced Conversions of Convertible Debt Instruments If the sweetener is a warrant, the fair value of the warrant becomes the inducement expense, recorded separately from the normal conversion entry.
When Bifurcation Is Still Required
The single-liability model handles most convertible notes, but ASU 2020-06 did not touch ASC 815. If a conversion feature qualifies as a derivative that is not clearly and closely related to the debt host, it must still be bifurcated and accounted for separately.8Deloitte Accounting Research Tool. Special Accounting Models – 7.6 Convertible Debt The ASC 815-15-25-1 criteria for bifurcation require all three of the following:9Deloitte Accounting Research Tool. Bifurcation Criteria – 8.3
- The embedded feature’s economic characteristics are not clearly and closely related to those of the debt host. An equity conversion feature in a debt instrument meets this test because equity values behave differently from interest rates.
- The hybrid instrument is not already remeasured at fair value through earnings each period.
- A separate instrument with the same terms would meet the definition of a derivative under ASC 815-10.
When bifurcation is required, allocate the initial proceeds between the derivative component (at fair value) and the debt host (as the residual). The derivative is then marked to market through the income statement every reporting period, creating non-cash gains and losses that can swing earnings significantly. The debt host carries at amortized cost, with any resulting discount amortized as additional interest expense over the note’s life using the effective interest method.10Deloitte Accounting Research Tool. Subsequent Accounting for Debt – 6.2 Interest Method
Features that tend to trigger bifurcation include conversion rates tied to future revenue or stock price, variable conversion ratios that reset based on market conditions, and complex cash settlement provisions. Standard conversion features in a typical startup note, where the holder receives a fixed formula price at a qualifying round, generally don’t require bifurcation. If there’s any doubt, get a valuation specialist involved. Getting this wrong creates material misstatements that auditors will flag.
The Fair Value Option
Companies can elect to measure the entire convertible note at fair value through earnings under ASC 825, sidestepping amortized cost entirely. When this election is made, the note is initially recorded at fair value (which may differ from the proceeds received), issuance costs cannot be deferred, and every subsequent reporting period the note is remeasured to fair value with changes running through the income statement.11PwC Viewpoint. Accounting for Debt at Fair Value After Adoption of ASU 2020-06
The election is irrevocable and introduces the same kind of earnings volatility that bifurcated derivatives create. Most startups don’t elect it, because the amortized cost model is simpler and conversion usually happens within a year or two. It can be attractive for companies that would otherwise need to bifurcate a complex embedded derivative, because electing fair value for the entire instrument eliminates the need for bifurcation. Convertible instruments issued at a substantial premium are not eligible for this election.
Effect on Diluted EPS
Convertible notes affect earnings per share even before they convert. Under the if-converted method in ASC 260, diluted EPS assumes the note was converted into common shares at the beginning of the period (or the issuance date, if later). The shares that would be issued on conversion are added to the denominator, and the interest expense (net of tax) that would have been avoided is added back to the numerator.12Deloitte Accounting Research Tool. Diluted EPS – 4.4 If-Converted Method
There is an antidilution guardrail. If the assumed conversion would increase EPS rather than decrease it, exclude the convertible note from the diluted calculation entirely. Convertible debt is antidilutive whenever its interest per common share obtainable on conversion exceeds basic EPS.12Deloitte Accounting Research Tool. Diluted EPS – 4.4 If-Converted Method For early-stage companies already reporting net losses, this check usually means the convertible note gets excluded from diluted EPS, because adding shares to the denominator while adding back interest expense to a negative numerator would reduce the reported loss per share.