FASB Implements Clearer Rules for Convertible Debt Settlements

24 Feb 2025 FASB Implements Clearer Rules for Convertible Debt Settlements

The Financial Accounting Standards Board (FASB) has issued Accounting Standards Update (ASU) 2024-04, a long-awaited clarification on how companies should account for certain convertible debt settlements. The core issue? For years, there’s been confusion about whether these transactions should be treated as induced conversions or debt extinguishments.

The way a company accounts for these transactions can determine whether it records a taxable gain, a deductible expense, or an unexpected earnings swing. Companies that previously used inducement accounting without properly preserving the original deal structure might now find their transactions classified as extinguishments, leading to unintended gains or losses. With these changes, issuers must carefully evaluate how their convertible debt agreements are structured to avoid surprises.

Background

Convertible debt has long been a favored financing tool, offering companies a way to raise capital at lower interest rates while giving creditors the option to convert debt into equity. But when it comes to accounting for settlements, things haven’t been so straightforward.

Historically, companies had three different accounting models to navigate:

Conversion accounting

Conversion accounting is applied when the settlement occurs under the original terms of the agreement. The company simply transfers the carrying amount of the debt to equity, with no gain or loss recognized. For instance, let’s say a company issued convertible debt that allowed holders to convert their bonds into 100 shares per $1,000 of debt. If the company follows the original contract terms, it simply transfers the debt to equity—no gain, loss, or expense is recorded.

Extinguishment accounting

Extinguishment accounting is applied when the settlement substantially alters the original deal, meaning the company must record a gain or loss based on the difference between the debt’s carrying amount and the fair value of what’s given in exchange.

For instance, if the company negotiates a new deal with bondholders, agreeing to settle the debt for 120 shares per $1,000 debt rather than the original 100 – this would likely be considered a fundamental change. So, the company must compare the carrying amount of the debt to the fair value of the 120 shares given in exchange. If the fair value of the shares issued differs from the debt’s carrying amount, a gain or loss is recorded.

This can be problematic if it results in large, unexpected gains or losses; however, companies may still choose this method if they want to settle the debt in a way that optimizes capital structure or eliminates liabilities at a discount.

Induced conversion accounting

Induced conversion accounting applies when the company offers an extra incentive (a “sweetener”) to encourage debt holders to convert early. This results in an inducement expense recorded on the income statement.

For instance, let’s say the company wants to encourage early conversion to clean up its balance sheet and avoid future interest payments. To entice bondholders, it offers 10 extra shares (totaling 110 shares per $1,000 debt). Since the original consideration (100 shares) remains, but the company added a sweetener of 10 extra shares, it could qualify as an induced conversion. The company must recognize an inducement expense equal to the fair value of the 10 extra shares.

Essentially, inducement accounting results in a tax-deductible business expense because inducement only happens when a company adds extra value to encourage conversion. This is generally more favorable than extinguishment for tax purposes because extinguishment can potentially result in a gain in taxable income. Even if extinguishment results in a loss, it’s generally not as favorable (tax-wise) as an inducement expense because it may be limited or deferred.

The problem before ASU 2024-04

In practice, companies struggled with gray areas, especially when dealing with cash settlements and cases where conversion features weren’t yet exercisable.

If a company offered cash instead of equity, was it an induced conversion or an extinguishment? If a bondholder wasn’t yet eligible to convert under the original terms, but the company still encouraged early conversion, would that be treated as an inducement or an extinguishment?

These uncertainties led to inconsistent accounting treatment across companies, which FASB aimed to resolve with ASU 2024-04.

Key Changes in ASU 2024-04

Given the confusion around cash settlements, conversion timing, and fair value preservation, ASU 2024-04 makes several targeted updates. Here’s what’s new:

Induced conversions now apply to cash-settled deals

Previously, the concept of induced conversion was closely tied to equity settlements. If a company offered cash instead of shares, the accounting treatment was murky—should it be an inducement or an extinguishment?

Under ASU 2024-04, induced conversion accounting can apply regardless of whether the settlement is in equity or cash, as long as the core principles (i.e., offering a sweetener while preserving the original consideration) are met.

Clearer definition of a “substantive” conversion feature

A key issue before the update was whether inducement accounting applied if the conversion feature wasn’t yet exercisable when the incentive was offered.

ASU 2024-04 clarifies that an inducement can still occur even if the conversion option isn’t immediately exercisable—provided that the conversion feature was substantive when issued and remains substantive when the inducement is offered.

So, what makes a conversion feature substantive? It must have real economic value and a genuine likelihood of conversion. For instance, a conversion price that’s reasonably close to market value at issuance creates a real incentive for bondholders to convert and is substantive. A conversion price set so high that conversion is unrealistic is not substantive.

This prevents companies from manipulating conversions by adding or modifying features shortly before settlement to achieve a more favorable accounting treatment.

The “preservation of consideration” principle

One of the biggest drivers of uncertainty was whether changes in settlement terms affected how transactions were classified.

The updated guidance states that for a settlement to qualify as an induced conversion, the original consideration must remain “preserved” in both form and amount—with any additional incentives treated separately as an inducement expense.

If a company originally promised 100 shares per $1,000 debt and later offers 10 bonus shares to encourage conversion, that’s generally an induced conversion because the original deal is still intact.

However, if the company changes the settlement to 50 shares + cash instead of the original 100 shares, that’s not an inducement—it’s an extinguishment because the fundamental deal structure has changed.

VWAP adjustments no longer automatically trigger extinguishment accounting

Many convertible instruments use volume-weighted average price (VWAP) formulas to determine the number of shares or cash received at settlement. Previously, it wasn’t clear whether modifying or incorporating a VWAP feature meant an automatic extinguishment.

ASU 2024-04 clarifies that a VWAP formula alone does not trigger extinguishment accounting. Instead, companies must evaluate whether the fair value of consideration remains consistent with the original terms. If fair value is preserved, the modification does not automatically result in an extinguishment.

How to determine if a conversion is “induced” under the new rules

Under ASU 2024-04, a settlement is classified as an induced conversion only if it meets all three of the following criteria:

• Limited-Time Offer – The issuer modifies the conversion terms for a short window to encourage immediate or near-immediate conversion.

• Preservation of Consideration – The original form and amount of consideration must be maintained, with sweeteners added on top rather than replacing the fundamental structure.

• Substantive Conversion Feature – The convertible feature must have economic substance at issuance and at the time of the inducement offer.

If a transaction fails any of these tests, it defaults to extinguishment accounting, meaning a gain or loss must be recognized.

When inducement accounting does apply, the issuer records an inducement expense, calculated as the fair value paid to settle the debt (including any sweeteners) minus the fair value of the original conversion consideration.

Transition and effective date

ASU 2024-04 is effective for fiscal years beginning after December 15, 2025, including interim periods within those years.

However, early adoption is permitted as long as the company has already adopted ASU 2020-06 (which made other changes to convertible instrument accounting).

How to adopt the changes

Companies can choose between two transition methods:

1. Prospective Adoption – Apply the new rules only to settlements occurring after the effective date.

2. Full Retrospective Adoption – Restate prior periods and recognize any cumulative-effect adjustments in equity as of the later of the following dates: (1) the beginning of the earliest period presented and (2) the date the company adopted the amendments in ASU 2020-06.

Either way, disclosure of the nature and impact of the change is required.

Final thoughts: what this means for companies

The new rules are designed to reduce ambiguity, ensure consistent accounting treatment, and reflect the economic reality of modern financing structures.

For companies with existing convertible debt agreements or those considering modifications, now is the time to evaluate how the new rules apply to outstanding debt, assess whether early adoption makes sense, and review past transactions to determine if retrospective adoption is necessary.

If you’d like personalized assistance or guidance, please contact our office. 

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