Accounting for Stock Warrants

A stock warrant is a financial contract between a company and investors, which gives them the right to purchase newly issued shares of a stock at a set price for a set period of time. The company directly issues the new stock instead of using issued stock. However, investors that get a stock warrant do not have a legal right to the ownership of stock, but only a right to purchase it in the future. Similarly, for the company, a stock warrant does not lock in investors to buy the stock. They still have a choice of not exercising the right.

Since the warrant sets the price of the newly issued stock, it can be beneficial to the investors. Especially when the price of the company’s stock rises in the stock market, investors can profit from the lower price of stocks offered to them through warrants. Similarly, the market price of the stock of a company will not affect the price of the warrant, as the company issues the new stocks, and the price is preset.

There are many different types of stock warrants that companies may put into use. The two main types of stock warrants are put and call warrants. A put warrant limits the amount of equity that the investor can sell back to the company at a given price. A call warrant, on the other hand, guarantees the investor’s right to purchase a predetermined number of shares at a predetermined price. There are also other types of warrants such as covered, naked, traditional, and wedded warrants. These are classified based on the degree of risk and value of the warrant.

Accounting for Stock Warrants

Companies may use stock warrants in one of two ways. Firstly, they can issue stock warrants on their own to investors that are willing to invest in them. On the other hand, companies may also pay suppliers in stock warrants in exchange for the goods or services they provide.

Based on which classification the stock warrants come under, the accounting treatment will differ. For the first scenario, where companies issue share warrants to investors, the accounting treatment will come under IFRS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments. When issued in exchange for goods or services, the accounting treatment will fall under IFRS 2 Share-Based Payments.

Accounting Treatment under IAS 32 and IFRS 9

The accounting treatment for share warrants under financial instrument standards requires companies to determine whether these have characteristics of financial liability or equity. Even though share warrants result in equity settlements, they may have characteristics of financial liability. The treatment for both scenarios will differ.

With the equity presentation, the grantor must recognize the share warrants as follows.

Dr Cash

Cr Share Capital

Cr Warrant Reserves

Under IFRS 9, the grantor does not need to make any subsequent remeasurements for stock warrants classified as equity. However, that case does not apply to stock warrants classified as a financial liability.

Under the financial liability treatment, the grantor must separate the equity and financial liability of stock warrants. They can do so by establishing a fair value for the warrants and treating that amount as equity. The accounting treatment will be as follows.

Dr Cash

Cr Financial Liability

Cr Share Capital

Unlike the equity treatment, the grantor must remeasure any stock warrants classified under financial liability at fair value. The grantor must then take any changes in the value to the profit or loss account. The accounting treatment, assuming the financial liability increases, will be as follows.

Dr Fair value movement expense (Profit or Loss)

Cr Financial Liability

At the exercise date, the grantor must transfer the amount for warrants classified as equity to another account within equity. In case of financial liability treatment, the grantor must revalue the warrants before settlement. They must then take any difference in the value to the profit or loss account. The same treatment applies to the expiry of warrants.

Accounting Treatment under IFRS 2

When it comes to accounting for stock warrants under IFRS 2, the company issuing them must ensure two things. First, the company must recognize the fair value of the equity instrument issued or the fair value of the consideration received, based on whichever is reliably measurable. Second, the company must recognize the asset or expense related to the goods or services at the same time.

If the option to exercise the stock warrant expires, the company cannot reverse the related expense or asset recognized. Furthermore, if a company receives warrants in exchange for products or services, it can recognize revenues normally, as they would under the accounting standard related to revenue.

Once the company determines the fair value of the stock warrant, the company can use the following accounting treatment to account for the transaction.

Dr Expense/Asset

Cr Stock warrants

When the investor exercises the option to avail the stock warrants, the company can use the following accounting treatment to convert the stock warrant balance into equity.

Dr Stock warrants

Cr Share capital

Cr Share premium

The value of the share capital and share premium will depend on the original fair value measurement of the company.

For transactions involving performance obligations, companies must record the transaction on the earlier of one of the two measurement dates. The first date is when the grantee completes the performance obligations involved with the transaction.

The second date is when the grantee’s commitment to complete is probable, including the presence of large disincentives related to nonperformance. If the grantee fails to complete the performance obligations at a specified time, the grantor cannot record the transaction.

On the grantee’s side, the accounting treatment for stock warrants will be similar. However, instead of using cash as a settlement, the grantee must use equity instruments. The grantee must, therefore, recognize the fair value of the equity instruments using the same method used by the grantor. For contingent performance obligations, the grantee may need to change the amount of the revenue it recognizes.

Example

A company, Red Co., obtains services from another company, Blue Co. The value of the services obtained is $100,000. Instead of paying Blue Co. by cash, Red Co. issues stock warrants for the services. Since Red Co. issued the stock warrants in exchange for services, the IFRS 2 treatment for stock warrants will apply.

Therefore, Red Co. must determine the fair value of the warrants. Since the company can reliably measure the value of services provided by Blue Co., it can use the amount to record the transaction. Therefore, Red Co. will record the transaction as follows.

Dr Services $100,000

Cr Stock Warrants $100,000

At the exercise date, Blue Co. chooses to exercise its rights to buy shares at a lower price. Therefore, Red Co., will transfer the amount to its equity accounts. Of the total value, only $80,000 will be a part of the share capital account as determined by the company. Red Co. will use the following accounting treatment to record the transfer.

Dr Stock Warrants $100,000

Cr Share Capital $80,000

Cr Share Premium $20,000

Valuation of Stock Warrants

A warrant can be valued using the binomial tree approach. Dilution needs to be taken into consideration. Basically, the valuation proceeds as follows,

  1. Build a tree for the underlying stock
  2. Calculate the warrant value at each end node of the tree.
  3. Move on to the previous time step and calculate the warrant value at each node on this time slice using the warrant values at the precedent nodes.
  4. After the warrant value is calculated at a node, check whether early exercise is allowed and optimal. The warrant price at this node is then the greater of this value and the payoff of the early exercise.
  5. Continue in this manner until the warrant is valued at all nodes of the tree.
  6. The value at the root node of the tree is the price of the warrant at the valuation date.

Conclusion

A stock warrant gives investors the right to purchase newly issued shares of a company at a set price within a set period of time. The accounting treatment of stock warrants requires the company to determine the fair value of the stock warrant at the date of measurement. When the investor exercises the right to buy shares, the company must convert the stock warrant’s balance to equity.

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