A company issues $1,000,000 of convertible bonds at par. The bonds pay 4% interest. Similar non-convertible bonds pay 6%. Under U.S. GAAP, how should the proceeds be allocated at issuance?

Answer options:

All proceeds are allocated to the liability (Bonds Payable).

Proceeds are allocated between debt and equity based on relative fair values.

Proceeds are allocated to debt based on the PV of cash flows at 6%, with the residual to equity.

All proceeds are allocated to equity.

How to approach this question

Recall US GAAP vs IFRS on Convertible Debt. US GAAP: Generally all Debt (unless specific exceptions like Cash Conversion). IFRS: Split accounting (Liability + Equity). ASU 2020-06 removed the separation models for BCF and Cash Conversion, aligning closer to 'All Debt' for most convertibles.

Full Answer

A.All proceeds are allocated to the liability (Bonds Payable).✓ Correct

Under current U.S. GAAP (ASU 2020-06), for traditional convertible debt (where the principal must be repaid in cash or stock at the issuer's option or holder's option, but not mandatorily cash settled), the instrument is accounted for as a single liability. There is no separation of the conversion option into equity.

Common mistakes

Applying IFRS split accounting rules.

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