A convertible note accounting entry follows three moments in the note’s life: issuance, periodic interest accrual, and either conversion into equity or cash repayment at maturity. At issuance you debit Cash and credit Convertible Note Payable for the face amount. Each period you debit Interest Expense and credit Accrued Interest Payable. At conversion you clear both liabilities and credit the stock account for par value with the remainder posting to Additional Paid-in Capital. Under current U.S. GAAP, most convertible notes are carried as a single liability at amortized cost, so no discount, no equity component, and no bifurcation of the conversion option muddies the entry.1PwC Viewpoint. ASU 2020-06 Debt with Conversion and Other Options
ASU 2020-06 eliminated the beneficial conversion feature model and the cash conversion model, and by fiscal years beginning after December 15, 2023 every entity follows the simplified single-liability approach.2FASB. ASU 2020-06 Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity If you find older guidance describing BCF splits into APIC, ignore it for any note you’re recording today.
The Issuance Entry
When the investor’s wire clears, book the full face value in one line. A $500,000 convertible note produces a $500,000 debit to Cash and a $500,000 credit to Convertible Note Payable. Nothing gets carved off to equity, because the embedded conversion feature stays inside the debt host under the single-liability model.1PwC Viewpoint. ASU 2020-06 Debt with Conversion and Other Options
Then decide where the credit sits on the balance sheet. If maturity falls within twelve months of the balance sheet date, or if the holder can demand repayment inside that window, the note belongs in current liabilities. The same applies when the issuer could be required to settle any part of the conversion value in cash, even if the conversion option is out of the money.3Deloitte Accounting Research Tool. Balance Sheet Classification – 13.10 Convertible Debt
Most early-stage notes are non-current. They convert on a qualified financing round that hasn’t happened yet, the conversion right is share-settled, and share-settled conversion doesn’t drag 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 interest rate, and that interest is recognized as it accrues whether or not cash is paid. In practice, startup notes rarely pay cash interest during the term. The interest just builds until conversion or maturity.
The periodic entry is a debit to Interest Expense and a credit to Accrued Interest Payable. Interest Expense lands on the income statement and reduces net income. Accrued Interest Payable stacks on the balance sheet as a liability that will eventually convert into equity alongside the principal or get paid in cash at maturity.
PIK Interest
Some notes include a paid-in-kind feature, where accrued interest rolls into the note’s principal balance instead of sitting in a separate liability account. Under a PIK arrangement, the issuer is effectively issuing additional debt to settle the interest obligation.4Deloitte Accounting Research Tool. Embedded Commitments Including PIK Interest and Dividend Features The entry becomes a debit to Interest Expense and a credit directly to Convertible Note Payable. The result is a higher principal balance that will convert into more shares when the trigger event occurs.
The Conversion Entry
Conversion is the entry that reshapes the balance sheet. Under ASC 470-20-40-4, when a convertible note accounted for entirely as a liability converts into shares per its original terms, the carrying amount (including any unamortized premium, discount, or issuance costs) is reduced by any cash paid and then recognized in the capital accounts. No gain or loss hits the income statement.5FASB. FASB Staff Document – ASC 470-20-40-4 Convertible Debt Conversions
Debit Convertible Note Payable for the principal. Debit Accrued Interest Payable for the accumulated interest. Credit the stock account (Common Stock or Preferred Stock) for the par value of the shares issued. Credit Additional Paid-in Capital for the remainder.
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, calculated as the lower of the valuation cap price and the discounted round price, works out to $1.00 per share, so 105,000 shares of Preferred Stock are issued. Par value is $0.0001, so the stock account receives $10.50 (105,000 × $0.0001) and APIC receives the rest.
- 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 line is a rounding artifact for most venture-backed companies. Nearly the entire conversion value lands in APIC.
Cash Repayment at Maturity
If no qualifying financing round occurs before maturity, the company typically must repay principal and accrued interest in cash. The entry mirrors issuance and accrual in reverse: debit Convertible Note Payable for the principal, debit Accrued Interest Payable for accumulated interest, and credit Cash for the total disbursed.
No gain or loss runs through the income statement, because the interest was recognized during the accrual periods. A gain or loss on extinguishment arises only if the carrying value differs from the amount paid, which won’t happen on a standard note carried at face with interest accrued separately.
When Terms Change Before Conversion
Convertible notes get renegotiated more often than founders expect. ASC 470-50 asks whether the change is substantial enough to be an extinguishment or minor enough to be a modification. Extinguishment is triggered if any one of these applies:6Deloitte Accounting Research Tool. Determining Whether Debt Terms Are Substantially Different
- 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 fair value of the embedded conversion option changes by at least 10 percent of the original debt’s carrying amount.
- A substantive conversion option is added or removed.
Extinguishment accounting derecognizes the old note and books the new one at fair value, with any difference flowing through the income statement as a gain or loss. If none of the tests is triggered, treat the change as a modification and adjust the effective interest rate prospectively without touching the income statement.
Induced Conversions
When the company sweetens the deal to encourage early conversion, any additional consideration beyond the original terms 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 warrants are offered as a sweetener, their fair value becomes the inducement expense, booked separately from the normal conversion entry.
When the Standard Entries Don’t Apply
Two situations pull a convertible note out of the single-liability model and change the entries above.
The first is an embedded conversion feature that qualifies as a derivative under ASC 815. All three of the following must be true to require bifurcation:8Deloitte Accounting Research Tool. Bifurcation Criteria – 8.3 the embedded feature is not clearly and closely related to the debt host, the hybrid instrument is not already remeasured at fair value through earnings, and a standalone instrument with the same terms would meet the definition of a derivative. When bifurcation applies, initial proceeds are split between the derivative (at fair value) and the debt host (as the residual), the derivative is marked to market through earnings each period, and any resulting discount on the host is amortized as additional interest expense using the effective interest method.9Deloitte Accounting Research Tool. Subsequent Accounting for Debt – 6.2 Interest Method Features that tend to trigger this treatment include conversion rates tied to future revenue or stock price, variable conversion ratios that reset with market conditions, and complex cash settlement provisions. Standard startup terms (a fixed formula price at a qualifying round) generally don’t require bifurcation.10Deloitte Accounting Research Tool. Special Accounting Models – 7.6 Convertible Debt
The second is an election to measure the entire note at fair value through earnings under ASC 825. Under this election the note is initially recorded at fair value (which may differ from proceeds received), issuance costs cannot be deferred, and each reporting period brings a remeasurement 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 instruments issued at a substantial premium are not eligible. Most startups don’t elect it because the amortized cost model is simpler, but it can be useful when the alternative would be bifurcating a complex embedded derivative.
How the Note Affects Diluted EPS
Even before conversion, the note affects diluted earnings per share. Under the if-converted method in ASC 260, diluted EPS assumes the note converted at the beginning of the period (or the issuance date, if later). Shares that would be issued on conversion go into the denominator, and 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
An antidilution check comes next. If the assumed conversion would raise EPS instead of lowering it, exclude the note from the diluted calculation. Convertible debt is antidilutive whenever its interest per common share obtainable on conversion exceeds basic EPS. Companies reporting net losses usually end up excluding the note on this ground, because adding shares to the denominator while adding interest expense back to a negative numerator would shrink the reported loss per share.