Convertible instruments include various forms of debt obligations that are not common stock or member interests in an LLC. However, they are convertible into equity or equity equivalents. The variety includes debt, bonds, and preferred stock, with conversion features or attached warrants. Convertibles allow the investor some downside protection (with interest), as well as upside potential when equity appreciates. The interest rate for a convertible is usually less than normal, since the instrument converts to equity.

The accounting for unique attributes of convertibles is very complex. FASB treats these convertibles as “hybrid instruments,” meaning contracts that include a host contract and an embedded derivative. These embedded portions that are deemed a liability must be recorded at fair value at each balance sheet date. The non-convertible debt interest rate must be separately accounted, possibly based upon ASC 815, ASC 470-20 and ASC 820 (Fair Value Measurement). Changes in fair value flow through earnings.

While all convertibles are initially measured at fair value, those classified as equity need not be re-measured. The ones accounted for as a separate liability are continually revalued. For example, warrants are instruments that are registered and traded separately. Since the holder has the right to receive a specific number of shares at a predetermined price and date, they are considered equity.


The simplest approach to valuing derivatives is as a straight bond with a call option. The closed-form option pricing model known as Black-Scholes can be utilized. However, this approach usually undervalues the convertible and conversion feature.

On the other hand, greater analytical flexibility is only attained by a lattice or binomial option pricing model. A decision tree is used to determine the optimum decision between the issuer and holder at various times.

Probabilities (up, down, and default) are layed out in a risk-neutral framework, such that the discounted stock value matches the current stock price. The value of the conversion feature, absent a call (issuer), a put (holder) or a forced conversion, is the difference between the convertible value when this feature is there, versus when it is removed. Absent the conversion feature, the value of the convertible is the same as a straight bond, or the host contract.