How to Classify Convertible Notes After ASU 2020-06

As of July 2026 · Written by Rohit Goel, US CPA · From the filing seat of a US-listed public company

ASU 2020-06 was sold as simplification, and for plain-vanilla converts it delivered: most convertible notes are now a single liability at amortized cost. But the simplification removed the models that used to absorb messy features, so the remaining question, does the conversion feature have to be bifurcated as a derivative?, now does all the work. Get it wrong and you are marking a derivative liability through earnings every quarter, or restating because you didn't. The 2021 SPAC warrant wave, triggered by the SEC staff's April 12, 2021 statement, put hundreds of companies through exactly that exercise.

This is the decision sequence I run on every convertible note at a sub-$500M issuer. The Convertible Debt & Embedded-Derivative Classifier at app.unfoldingvalues.com executes the same sequence against your term sheet; use it to pressure-test each step below.

What did ASU 2020-06 actually change in ASC 470-20?

Two separation models are gone:

• The beneficial conversion feature (BCF) model, no more measuring intrinsic value of an in-the-money conversion option at commitment and cramming it into APIC with a discount accreted through interest expense.
• The cash conversion (CCF) model, no more bifurcating Instrument C-style notes into a liability at the straight-debt rate plus an equity component.

What survives in ASC 470-20: the substantial premium model (debt issued at a substantial premium presumes the premium is paid-in capital), and the requirement to separate a conversion feature that must be bifurcated as a derivative under ASC 815-15. Post-adoption, the default is one instrument, one liability, amortized cost, with a lower reported interest expense than legacy GAAP, unless the derivative analysis says otherwise. That analysis is now the entire game.

When does an embedded conversion feature require bifurcation under ASC 815-15?

ASC 815-15-25-1 requires bifurcation when all three conditions are met:

1. The embedded feature's economics are not clearly and closely related to the host contract. An equity-conversion option in a debt host fails "clearly and closely related" essentially by definition, an equity return is not a debt return.
2. The hybrid instrument is not remeasured at fair value through earnings each period. If you elected the ASC 825 fair value option for the whole note, bifurcation stops here.
3. A separate instrument with the same terms would be a derivative under ASC 815-10.

For a conversion option, conditions (1) and (2) are usually satisfied, so everything turns on condition (3), and specifically on whether the feature qualifies for the scope exception in ASC 815-10-15-74(a) for contracts that are both (i) indexed to the entity's own stock and (ii) classified in stockholders' equity if freestanding. Fail either leg and you have a bifurcated derivative measured at fair value with changes through earnings. Both legs have their own tests, and both produced restatements in 2021.

How does the ASC 815-40 indexation test work?

ASC 815-40-15-7 sets a two-step evaluation.

Step 1: Do exercise contingencies break indexation?

An exercise contingency, a provision that makes conversion contingent on an event, does not preclude indexation unless the trigger is based on (a) an observable market, other than the market for the issuer's own stock, or (b) an observable index, other than one measuring the issuer's own operations (ASC 815-40-15-7A). So conversion contingent on a change of control, an IPO, a stock-price hurdle, or hitting a revenue target: fine. Conversion contingent on the S&P 500 level or the price of gold: indexation fails at step 1.

Step 2: Is the settlement amount fixed-for-fixed (or adjustable only by permitted inputs)?

The instrument is indexed to the issuer's stock only if the settlement amount equals the difference between the fair value of a fixed number of shares and a fixed strike (ASC 815-40-15-7C). Adjustments to that fixed-for-fixed baseline are tolerated only if the adjusting variables would be inputs to the fair value of a fixed-for-fixed option on the shares, stock price, strike, time, volatility, rates, dividends (ASC 815-40-15-7E). Standard anti-dilution mechanics (stock splits, dividends, spin-offs) generally pass. Adjustments driven by who holds the instrument, by the issuer's credit events, or by a future financing price generally do not.

Which features kill equity treatment most often?

Three recur constantly in small-cap paper:

Variable-rate conversion. A note converting at "80% of the lowest VWAP over the 10 days before conversion" delivers a fixed dollar value, not a fixed share count. The settlement amount doesn't move with the stock the way an option does, share count floats inversely to price. That fails step 2, full stop. These "market-price-discount" converts, the toxic/death-spiral structure, are bifurcated derivative liabilities, fair-valued through earnings every period. If your bridge lender's term sheet has a discount-to-VWAP formula, price the accounting cost before you sign.

Down-round (full-ratchet or weighted-average price-based) protection. A strike that resets when you sell stock cheaper introduces a variable (the future financing price) that is not an input to a fixed-for-fixed option. Pre-2017, that failed step 2. ASU 2017-11 created a targeted exception, codified at ASC 815-40-15-5D: a down-round feature, as defined, is disregarded when evaluating indexation. The tradeoffs: for equity-classified freestanding instruments (warrants), a triggered down round is recognized as a value transfer treated like a dividend, hitting EPS (ASC 260-10-25-1 and 30-1). Beware the definition's edges, the exception covers strike reductions from issuing shares at a lower price; a feature that also adjusts the number of shares beyond standard mechanics, or resets off something other than an equity issuance price, sits outside 815-40-15-5D and kills indexation the old-fashioned way.

Cash-settlement provisions. Even a feature that passes indexation must qualify for equity classification under ASC 815-40-25. The design principle: equity classification requires that share settlement be within the issuer's control. The classic conditions (ASC 815-40-25-10) include sufficient authorized and unissued shares, an explicit share cap, and no cash-settled top-off or make-whole; ASU 2020-06 removed or clarified three legacy conditions (unregistered-share settlement, collateral, and counterparty rights ranking). What still fails companies: provisions letting holders demand cash on events outside the issuer's control, the SPAC warrant tender-offer provision (all warrant holders could get cash while not all shareholders would) is the canonical 2021 example, and share caps that don't cover the maximum settlement scenario when a variable feature is in play.

What happens mechanically when bifurcation is required?

At issuance, measure the conversion feature at fair value and record it as a derivative liability; the debt host gets the residual, creating a discount accreted to par under the effective interest method. Every reporting date, remeasure the derivative through earnings, meaning your net income now moves inversely to your stock price (stock up, derivative liability up, earnings down), a dynamic you will explain to your board forever. You'll also carry a Level 3 fair value measurement with ASC 820 disclosures, a valuation specialist, and an audit workpaper burden that dwarfs the note itself. Run the term sheet through the free Convertible Debt & Derivatives classifier before closing; every problematic clause is negotiable at the term-sheet stage and immovable afterward.

How did ASU 2020-06 change EPS for convertibles?

Two changes with real dilution optics:

1. If-converted is mandatory. ASC 260-10-45-40, as amended, requires the if-converted method for convertible instruments in diluted EPS. The treasury stock method is no longer available based on an assertion or presumption of cash settlement, the ASU eliminated that accommodation. If the contract requires cash settlement of principal, only shares for the conversion spread are included; a mere issuer option to cash-settle no longer keeps shares out of the denominator.
2. No interest add-back distortion from separation. With the BCF/CCF discounts gone, the numerator add-back is the note's actual coupon and issuance-cost amortization, tax-effected.

Practical consequence: companies that adopted 2020-06 saw diluted share counts jump. Model it before issuing, a convert that looked EPS-friendly under the old treasury stock method can be visibly dilutive under if-converted, and your investor deck should not discover that after your first post-issuance 10-Q.

What is the decision tree, end to end?

1. Fair value option elected for the whole note? → No bifurcation; FVO accounting.
2. Conversion feature clearly and closely related? → No (equity in debt host); continue.
3. Indexed to own stock (815-40-15-7: step 1 contingencies, step 2 fixed-for-fixed, down rounds disregarded per 815-40-15-5D)? → If no: bifurcate.
4. Equity classification conditions of 815-40-25 met (share settlement within issuer control, authorized shares, share cap, no cash top-off)? → If no: bifurcate.
5. Otherwise: single liability at amortized cost under ASC 470-20 (check substantial-premium model), if-converted EPS under ASC 260.

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