Design Features that Drive the Fair Value of a Convertible Security

Convertible debt combines features of debt and equity, which gives rise to a unique set of financial reporting and fair value measurement challenges under generally accepted accounting principles (GAAP). Complicating matters is the fact that the applicable GAAP spans Accounting Standard Codification (ASC) Topics 470, 480, 815, and 820, and which particular construct applies to any given case will materially affect the magnitude and volatility of earnings charges.

This Issue Brief is about how decisions related to the terms of a convertible debt instrument affect the valuation of that security. Small details and provisions can cause large value swings. The fair value measurement required under GAAP leans on advanced quantitative modeling, further complicating matters.

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