Convertible Notes at IPO — ASC 470, ASU 2020-06, and the EPS Question

Convertible notes that are outstanding at the time of an IPO require careful accounting analysis under ASC 470-20 and related standards. The FASB's ASU 2020-06 (effective 2022 for public companies) significantly simplified this analysis by eliminating the requirement to separately account for the equity conversion feature in most cases — but it introduced a new EPS calculation requirement that has direct implications for the S-1.

The ASU 2020-06 Simplification

Before ASU 2020-06 (which took effect in 2022 for public companies and 2024 for private companies that early-adopted), convertible instruments often had to be bifurcated: the debt host was recorded at a discount, and the conversion feature was separately recognized in additional paid-in capital (APIC). This created non-cash interest expense from the discount amortization and complex accounting entries.

ASU 2020-06 eliminated this bifurcation requirement for most convertible instruments. Under the new model:

• The entire convertible note is recorded as a single liability (the combined debt instrument approach)
• No separate equity component is recognized in APIC for the conversion feature
• Interest expense is lower — no discount amortization from a separately recorded equity component
• The if-converted method for diluted EPS is now required (the treasury stock method is no longer permitted for convertible instruments)

Embedded Derivative Analysis

Even under the simplified ASU 2020-06 model, certain features of convertible notes may require separate accounting as derivatives under ASC 815. The analysis requires evaluating whether the conversion feature meets all three criteria for equity classification under ASC 815-40:

• The instrument is not required to be net cash settled
• The company has sufficient authorized and unissued shares
• The settlement criteria in the contract are within the company's control

For straightforward startup convertible notes with standard conversion mechanics, the equity classification criteria are typically met and derivative accounting is not required. However, notes with variable conversion rates, anti-dilution features tied to non-standard triggers, or settlement mechanics that depend on external factors may require derivative bifurcation under ASC 815-15.

The If-Converted Method for Diluted EPS

Under ASU 2020-06, the if-converted method is required for diluted EPS when a company has outstanding convertible instruments. This method assumes that all convertible notes were converted at the beginning of the period (or the issuance date if later), and includes the resulting shares in the diluted share count while adding back the after-tax interest expense to net income.

For pre-revenue or loss-stage IPO companies where diluted EPS is negative, the if-converted shares are typically anti-dilutive and excluded from the diluted share count — but this must be analyzed for each reporting period.

Accounting at Conversion

When a convertible note converts to equity at an IPO or priced round, the accounting entry derecognizes the debt liability and recognizes the equity issued. Under the simplified ASU 2020-06 model, the conversion is recorded at the carrying amount of the debt (principal plus accrued interest, net of any unamortized issuance costs), with no gain or loss recognized in most standard conversion scenarios.

S-1 Disclosure Requirements

The S-1 must fully disclose outstanding convertible notes, including:

• Principal amounts, interest rates, maturity dates, and conversion terms for each note or note series
• The accounting policy for the convertible notes and the basis for any classification decisions
• The diluted EPS impact using the if-converted method
• Risk factors disclosing that conversion will dilute existing shareholders
• Use-of-proceeds disclosure if IPO proceeds will be used to repay notes rather than convert them

Technical References

Settlement in Cash vs. Shares — Why It Matters

The convertible note instrument itself specifies how it can be settled at conversion: in shares only, in cash only, or in a combination of cash and shares. This settlement flexibility profoundly affects the accounting:

Most pre-IPO convertible notes are structured for mandatory share settlement at the IPO (converting to preferred or common stock) — so the full if-converted share count applies. But startup-stage convertible notes sometimes include a cash settlement option that triggers re-classification as a liability instrument. This matters for the S-1 balance sheet presentation and for diluted EPS.

SEC Comment Patterns on Convertible Note Accounting

The SEC consistently scrutinizes convertible note accounting in technology company S-1s. The most common SEC comments from 2022–2025:

• Beneficial conversion feature (pre-ASU 2020-06 notes): For notes issued before the effective date of ASU 2020-06, the SEC asks whether a beneficial conversion feature (BCF) was recognized — specifically, whether the note's conversion price was below the fair value of the underlying shares on the commitment date. BCF accounting required a debt discount that was accreted over the note's life.
• Modification vs. extinguishment: When a convertible note's terms are amended (maturity extended, interest rate changed, conversion price lowered), the SEC asks whether the modification was so significant that the old note should be treated as extinguished (with gain/loss recognition) and a new note recorded. The 10% cash flow test under ASC 470-50 is the primary test.
• Embedded derivative bifurcation: The SEC reviews whether any conversion features, put options, or call options in the convertible note should be bifurcated as a freestanding derivative under ASC 815. The analysis must be documented and the conclusion defensible — if the conversion feature is indexed to the company's own stock and would be classified as equity, bifurcation is not required.
• Classification as current vs. long-term: If the note matures within 12 months of the balance sheet date, or if the holder has a put option that could force repayment within 12 months, the note must be classified as a current liability — even if the company expects to convert it. The SEC watches for misclassification of near-term notes as long-term.

S-1 Balance Sheet Presentation

The S-1 balance sheet shows the company's financial position at the most recent balance sheet date — which typically includes outstanding convertible notes as liabilities. The presentation requirements:

• Convertible notes are presented as a single line item ("Convertible notes, net") on the balance sheet, with the unamortized debt issuance costs netted against the principal balance
• The footnote disclosure must specify: principal amount, interest rate, maturity date, conversion terms (price per share or conversion mechanics), and any embedded features
• A separate pro forma balance sheet column (or note disclosure) must show the effect of converting all notes to common stock at the IPO — showing how the balance sheet looks immediately after effectiveness before trading begins
• If the convertible notes will be repaid from IPO proceeds rather than converting, the use of proceeds section must disclose the specific amounts to be repaid, the interest rate, and the name of the lender