Detachable warrants act as freestanding instruments that companies use to attract investors. Generally, companies attach stocks with debt instruments such as bonds to attract investors.
Detachable warrants offer several benefits to the issuers. The accounting treatment of detachable warrants largely depends on the classification of the warrants into liability or equity.
Let us discuss what detachable warrants and their accounting treatment are.
What are Detachable Warrants?
A detachable warrant is a derivative attached to another financial security that the holder can use to purchase that security within a specific time and at a specified price.
Detachable warrants are often issued as common stocks. These stocks can be detached from an underlying security. An investor can sell these warrants separately from the underlying security in the secondary market.
When investors purchase security with detachable warrants, they have several options. The investor can sell the warrants (stocks) and hold the underlying security. The investor can hold the warrants and sell the underlying security (often a bond) in the secondary market.
Detachable warrants give the holder the right and not an obligation to sell the underlying security. It means the investor can let the option expire without exercising the right to purchase the security and only recover the debt at maturity.
Why Companies Issue Detachable Warrants?
Often, companies use detachable warrants to attract investors. A common use of detachable warrants comes with the bonds.
Detachable warrants can also attract investors that usually do not participate in fixed-income instruments. Thus, the option of attaching warrants to underlying security such as a bond attracts more investors.
Another common reason for issuing detachable warrants is to lower the cost of borrowing. When the issuer attached detachable warrants with a bond, it can afford to offer a lower interest rate on the bond than a bond without them.
Investors get compensated for additional stocks at lower prices. They can purchase additional stocks from the debt issuer or sell the warrants to convert them into cash immediately.
When an issuer issues debt (commonly in the form of a bond) with detachable warrants, both securities act as different instruments. Although detachable warrants have similar features, they are different from call options. Thus, the holder can sell the bond, warrant, or both, or hold both of them till the option expires.
Accounting for Detachable Warrants – ASC 470
Warrants are one of the many freestanding instruments that companies often issue. The accounting treatment for warrants is also similar to these freestanding instruments.
One of the important points with warrants is to determine whether they should be accounted for as equity or liability. The accounting treatment for warrants would differ accordingly.
Detachable warrants can be detached and sold in the secondary market. Thus, they act as freestanding instruments that can be traded independently of the underlying security.
When detachable warrants can be categorized as equity, then the proceeds received should be recorded on the fair value of the underlying security (the base instrument).
ASC 470-20-25-2 guides on the accounting treatment of detachable warrants that are classified as equity:
“Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt instrument portion of the transaction”.
ASC 470-20-25-2 specifically guides on the accounting treatment for warrants attached with debt instruments such as bonds. However, the accounting treatment is the same for preferred shares issued with detachable warrants as well.
Suppose ABC Company issued $ 1,000 of debt and 100 detachable warrants. The investors can buy ABC company’s stocks in exchange for $ 1,000 when the option is exercised.
We assume that ABC Company has classified the detachable warrants as equity. ABC company assumed 75% of the $ 1,000 consideration received is debt portion ($ 750) and 25% ($ 250) is equity.
Then, the journal entry to record the transaction will be:
|Discount on Debt||$250|
|Debt Instrument (Bond)||$1,000|
|Additional Paid-in Capital for Warrants||$250|
The company should allocate the proportion of debt and equity using the book value of the debt instrument at the time of issuance.
Warrants Issued as liability
Detachable warrants issued can be categorized as a liability by the issuer as well. When the company would record the detachable warrants at their fair value, the proceeds would also be recorded at the fair value allocated to the warrants.
The remaining proportion of the proceeds would then be allocated to the debt or equity instrument. Recording the proceeds this way avoids any gains or losses on day one of the conversion of warrants that could result from the accounting as a relatively fair value.
Continuing with our example above, we assume that ABC company issued the same instrument with the detachable warrants.
Suppose ABC Company has classified the detachable warrants as liability this time.
First, ABC company would allocate the fair value of the debt and liability in the same proportion as calculated previously.
|Item||Book Value||Fair Value||% Of Fair Value|
|Debt||$ 750||$ 900||75%|
|Warrants||$ 250||$ 300||25%|
|Total||$ 1,000||$ 1,200||100%|
ABC company has classified the detachable warrants as a liability. Thus, the proceeds will be allocated at fair value to the warrants first. The residual proceeds will be allocated to the debt instrument then.
The journal entry to record the transaction for ABC company will be:
|Discount on Debt||$300|
|Debt Instrument (Bond)||$1,000|
Issuance Costs of Detachable Warrants
The issuing company would account for the issuance costs of detachable warrants the same way as it would for the warrants. It means both accounting treatments should be consistent.
When the issuance costs are specifically classified for the issuance of a freestanding instrument such as detachable warrants, they’ll be allocated to that instrument. For instance, the issuance costs of detachable warrants issued with debt would be allocated to the detachable warrants issuing expense account.
When issuance costs are not specifically categorized should be allocated proportionally for the debt and detachable warrants accordingly. These costs should be expensed in the accounting period when incurred.
Detachable Warrants Issued for a Line of Credit
Companies can issue detachable warrants to obtain a line of credit as well. These warrants should be recorded at their fair value when the line of credit agreement is signed.
This accounting treatment of warrants should be adopted whether the warrants are classified as debt or equity. Although ASC 470-20-25 does not specifically apply to detachable warrants issued to obtain a line of credit.
Issuance of detachable warrants to secure a line of credit resembles a loan commitment. Even when the company fully utilizes the line of credit on the first day, the accounting treatment for the detachable warrants would remain the same.
Accounting for Put Warrants
A similar case to detachable warrants arises with put warrants. Companies can issue put warrants to attract investors as well.
The investor can exercise the put option or get cash from the issuer using the put feature in the contract. The company can generally record the proceeds from put options as equity.
In some cases, the issue price of the put option can be significantly higher than the value assigned to the put warrant. In such cases, the company should record warrants as a liability rather than equity.
Suppose a company ABC issues 100 bonds with put warrants. These bonds allow investors to purchase one share of ABC company with a par value of $1 and a price value of $ 20 after three years.
The stock price at the issuance date is $ 23. The bonds are puttable for $ 5 that the company allocates to warrants.
The investors can sell the stocks at $ 23 in the secondary market. However, the $ 3 gain ($ 23 – $ 20) is less than the $ 5 puttable feature. Thus, investors would not exercise it.
ABC Company will record the initial liability journal entry as:
|Liabilities – Put Warrants||$500|
The subsequent accounting entries for put warrants can be recorded with adjustments as well. Suppose the share price of ABC falls to $ 20. The Put warrants have clearly no value at this time.
Suppose an investor puts 50 warrants back after three years when the stock price of ABC company falls to $ 20.
The journal entry for ABC company will be:
|Cash (50 × $ 5 Put value)||$250|
|Liabilities – Put Warrants||$250|
Similarly, if the stock price of ABC company increases, the accounting entry for a conversion can be recorded at the transaction date.